Ch.

22: Perfect Competition

Del Mar College

John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
 The Theory of Perfect
Competition
• Basics: A market
structure is a firm’s
particular
environment.
• Perfect Competition
Theory is a theory of
market structure based
on 4 assumptions.
Perfect Competition Assumptions
• There are many sellers and many buyers, none of
which is large in relation to total sales or
purchases.
• Each firm produces and sells a homogeneous
product.
• Buyers and sellers have all relevant information
about prices, product quality, sources of supply,
and so forth.
• Firms have easy entry and exit.
Perfectly Competitive Firms are
Price Takers
• A price taker is a seller that does
not have the ability to control
the price of the product it sells;
it takes the price determined in
the market.
• A firms is restrained from being
anything but a price taker if it
finds itself one among many
firms where its supply is small
relative to the total market
supply, and it sells a
homogeneous product in an
environment where buyers and
sellers have all relevant
information.
 The Demand Curve for a
Perfectly Competitive Firm is
• When the
Horizontal!
equilibrium
price has been
established, a
single
perfectly
competitive
faces a
horizontal
demand curve
at the
equilibrium
price.
The Marginal Revenue Curve of
a Perfectly Competitive Curve is
the Same as its Demand Curve
• The firm’s marginal revenue is the change in total
revenue that results from selling one additional
unit of output.
• Notice that marginal revenue at any output level is
always equal to the equilibrium price. For a
perfectly competitive firm, price is equal to
marginal revenue.
• The marginal revenue curve for the perfectly
competitive firm is the same as its demand curve.
 The Demand Curve and the
Marginal Revenue Curve for a
Perfectly Competitive Firm
Theory and Real World Markets
A market that does not
meet the assumptions of
perfect competition may
nonetheless approximate
those assumptions to such
a degree that it behaves as
if it were a perfectly
competitive market. If so,
the theory of perfect
competition can be used to
predict the market’s
behavior.
 Q&A
• A price taker does not have the ability to control the
price of the product it sells. What does this mean?
• Why is a perfectly competitive firm a price taker?
• The horizontal demand curve for the perfectly
competitive firm signifies that it can not sell any of its
product for a price higher than the market equilibrium
price. Why can’t it?
• Suppose the firms in a real-world market do not sell a
homogenous product. Does it necessarily follow that
the market is not perfectly competitive?
Perfect Competition in the Short Run
• The firm will continue to increase its
quantity of output as long as marginal
revenue is greater than marginal cost.
• The firm will stop increasing tits quantity of
output when marginal revenue and marginal
cost are equal
• The Profit – Maximization Rule: Produce
the quantity of output at which MR=MC
The Quantity of Output the Perfectly
Competitive Firm Will Produce
The firm’s demand
curve is horizontal
at the equilibrium
price. Its demand
curve is its
marginal revenue
curve. The firm
produces that
quantity of output
at which MR=MC
 Resource Allocative Efficiency
and Productive Efficiency
• A firm that produces the quantity of output
at which Price = Marginal Cost is said to
exhibit resource allocative efficiency.
• A firm that produces its output at the lowest
possible per unit cost is said to exhibit
productive efficiency.
The Perfectly Competitive Firm and
Resource Allocative Efficiency
For the perfectly Because P=MR and MR=MC, it follows that
competitive firm, P=MC, that is the perfectly competitive firm
P=MR. Also, the exhibits resource allocative efficiency.
firm maximizes
profits or
minimizes losses
by producing
that quantity of
output at which
MR=MC.
Profit Maximization and Loss Minimization for
the Perfectly Competitive Firm: Three Cases
 Profit Maximization and Loss
Minimization for Perfect Competition
• A firm produces in the short run as long as price is
above average variable cost.
• A firm shuts down in the short run if price is less
than average variable cost.
• A firm produces in the short run as long as total
revenue is greater than total variable costs.
• A firm shuts down in the short run if total revenue
is less than total variable costs.
What Should a Firm Do in the Short
Run?
The firm should produce in the short run as
long as price (P) is above average variable
cost (AVC). It should shut down in the
short run if price is below average variable
cost.
 Perfectly Competitive Firm’s
Short-Run Supply Curve
• Only a price above average
variable cost will induce
the firm to supply output.
• The Short-Run supply
curve is that portion of the
firm’s marginal cost curve
that lies above the average
variable cost curve.
 From Firm to Market Supply
Curve
• We can derive the Short-Run Market
(Industry) Supply Curve by horizontally
“adding” the short-run supply curves for all
firms in the market or industry.
• The supply curve is upward-sloping because
of the law of diminishing marginal returns
 Q&A
• If a firm produces the quantity of output at which MR=MC,
does it follow that it earns profits?
• In the short run, if a firm finds that its price is less than its
average total cost, should it shut down its operation?
• The layperson says that a firm maximizes profits when total
revenue minus total cost is as large as possible and positive.
The economist says that a firm maximizes profits when it
produces the level of output at which MR=MC. Explain
how the two ways of looking at profit maximization are
consistent.
• Why are market supply curves upward sloping?
Perfect Competition In The Long Run
The following conditions characterize long run
equilibrium:
1. Economic profit is Zero: Price is equal to short-
run average total cost (SRATC)
2. Firms are producing the quantity of output at
which Price is equal to Marginal Cost (MC)
3. No firm has an incentive to change its plant size
to produce its current output; that is,
SRATC=LRATC at the quantity of output at
which P=MC.
 Long Run Competitive
Equilibrium Exists When The
Following Occur
• There is no incentive
for firms to enter or
exit the industry
• There is no incentive
for firms to produce
more or less output.
• There is no incentive
for firms to change
plant size.
The Perfectly Competitive Firm
and Productive Efficiency
Productive Efficiency
is the situation that
exists when a firm
produces its output at
the lowest possible per
unit cost (lowest
ATC). The perfectly
competitive firm does
this in Long-Run
Equilibrium.
The Process of Moving from One Long-Run
Competitive Equilibrium Position to Another
 Industry & Cost Relationships
• In a Constant-Cost Industry, average total costs do
not change as output increases or decreases when
firms enter or exit the market or industry. Output
is increased without a change in the price of
inputs.
• In an Increasing-Cost Industry, average total costs
increase as output increases and decrease as output
decreases when firms enter and exit the industry.
This industry is characterized by an upward-
sloping Long-run supply curve.
 Long-Run Industry Supply Curves
In a Decreasing-Cost Industry, average total costs decrease
as output increases and increases as output decreases when
firms enter and exit the industry.
 What Happens As Firms Enter
An Industry In Search Of Profits?
• New firms bring down
the prices for
consumers; the market
can affect price and
profits.
• The potential benefits
that incumbent firms
can enjoy if they can
successfully limit
entry into the industry.
 Industry Adjustment to A
Decrease In Demand
• The analysis outlined for an increase in demand can be
reversed to explain industry adjustment to a decre4ase in
demand.
• Some firms in the industry will decrease production because
marginal revenue intersects marginal cost at a lower level of
output and some firms will shut down.
• In the Long Run, some firms will leave the industry because
price is below average total cost and they are suffering
continual losses. As firms leave the industry, the market
supply shifts leftward, and the equilibrium price rises.
• The equilibrium price will rise until long-run competitive
equilibrium is reestablished and at zero economic profits
 Differences in Costs, Differences in Profits:
Now You See It, Now You Don’t
At ATC1 for both This moves Cordero’s ATC curve
farmers, Cordero earns upward to the same level as Hancock’s,
profits and Hancock and Cordero earns zero economic
does not. Cordero profits. The profits have gone as
earns profits because payment (implicit or explicit) for the
the land he farms is of higher-quality, more productive land.
higher quality (more
productive) than
Hancock’s land.
Eventually, this fact is
taken into account, by
Cordero either paying
higher rent for the land
or incurring implicit
costs for it.
 Profit And Discrimination
• A firm’s discriminatory behavior can affect
its profits in the context of the model of
perfect competition.
• If a firm is in a perfectly competitive market
structure, it will pay penalties if it chooses
to discriminate.
• The greater the penalties, the less
discrimination there will be.
 Q&A
• If firms in a perfectly competitive market are earning
positive economic profits, what will happen?
• If firms in a perfectly competitive market want to produce
more output, is the market in long-run equilibrium?
• If a perfectly competitive market in long-run equilibrium
witnesses an increase in demand, what will happen to price?
• Suppose there are two firms, each of which produces
computer software. Firm A employs a software genius at
the same salary that Firm B employs a mediocre software
engineer. Will the firm that employs the software genius
earn higher profits than the other firm, ceteris paribus?
 Topics for Analysis within the
Theory of Perfect Competition
• Do Higher Costs mean • Will the perfectly
higher prices? competitive firm
• A rise in costs incurred advertise?
by one of many firms • What are the costs and
does not mean what are the benefits
consumers will pay of advertising?
higher prices
More Topics for Analysis
Supplier-Set price
versus Market-
Determined Price: Is
this Collusion or
Competition?
 Q&A
• In a perfectly competitive market, do higher
costs mean higher prices?
• Suppose you see a product advertised on
television. Does it follow that the product
cannot be produced in a perfectly
competitive market?