1 Chapter 23Perfect Competition

2 IntroductionMost gold mines in California ceased operations by the

1960s.Since 2007, a number of mining companies have modernized some of

these gold mines and begun extracting gold once again.To understand why
these gold mines were closed and reopened again, you must learn about the
theory of perfect competition—the topic of this chapter.

3 Learning ObjectivesIdentify the characteristics of a perfectly competitive

market structureDiscuss the process by which a perfectly competitive firm

decides how much output to produceUnderstand how the short-run supply
curve for a perfectly competitive firm is determined

4 Learning Objectives (cont'd)

Explain how the equilibrium price is determined in a perfectly competitive

marketDescribe what factors induce firms to enter or exit a perfectly
competitive industryDistinguish among constant-, increasing-, and
decreasing-cost industries based on the shape of the long-run industry supply
curve

5 Chapter OutlineCharacteristics of a Perfectly Competitive Market

StructureThe Demand Curve of the Perfect CompetitorHow Much Should the

Perfect Competitor Produce?Using Marginal Analysis to Determine the Profit-
Maximizing Rate of ProductionShort-Run Profits

6 Chapter Outline (cont'd)

The Short-Run Breakeven Price and the Short-Run Shutdown PriceThe

Supply Curve for a Perfectly Competitive IndustryPrice Determination Under
Perfect CompetitionThe Long-Run Industry Situation: Exit and
EntryLong-Run EquilibriumCompetitive Pricing: Marginal Cost Pricing

7 Did You Know That ...More than 1,600 U.S. auto dealerships closed during

2009?Ease of exit from an industry is a fundamental characteristic of the

theory of perfect competition —the topic of this chapter.
8 Characteristics of a Perfectly Competitive Market Structure

Perfect CompetitionA market structure in which the decisions of individual

buyers and sellers have no effect on market price

9 Characteristics of a Perfectly Competitive Market Structure (cont'd)

Perfectly Competitive FirmA firm that is such a small part of the total
industry that it cannot affect the price of the product or service that it sells

10 Characteristics of a Perfectly Competitive Market Structure (cont'd)

Price TakerA competitive firm that must take the price of its product as given
because the firm cannot influence its price

11 Characteristics of a Perfectly Competitive Market Structure (cont'd)

Why a perfect competitor is a price takerLarge number of buyers and

sellersHomogenous products are perfect substitutesBoth buyers and sellers have
equal access to informationNo barriers to entry or exit (any firm can enter or
leave the industry without serious impediments)

12 The Demand Curve of the Perfect Competitor

QuestionIf the perfectly competitive firm is a price taker, who or what sets the
price?

13 The Demand Curve of the Perfect Competitor (cont'd)

The perfectly competitive firm is a price taker, selling a homogenous

commodity with perfect substitutes.Will sell all units for $5Will not be able to
sell at a higher priceWill face a perfectly elastic demand curve at the going
market price

14 Figure 23-1 The Demand Curve for a Producer of Titanium Batteries

15 How Much Should the Perfect Competitor Produce?

Perfect competitor accepts price as givenFirm raises price, it sells nothingFirm

lowers its price, it earns less revenues than it otherwise wouldPerfect
competitor has to decide how much to produceFirm uses profit-maximization
model
16 How Much Should the Perfect Competitor Produce? (cont'd)

The model assumes that firms attempt to maximize their total profits.The
positive difference between total revenues and total costsThe model also
assumes firms seek to minimize lossesWhen total revenues may be less than
total costs

17 How Much Should the Perfect Competitor Produce? (cont'd)

Total RevenuesThe price per unit times the total quantity soldThe same as
total receipts from the sale of output

18 How Much Should the Perfect Competitor Produce? (cont'd)

Profit p = Total revenue (TR) – Total cost (TC)TR = P x QTC = TFC + TVCP is
determined by the market in perfect competitionQ is determined by the
producer to maximize profit

19 How Much Should the Perfect Competitor Produce? (cont'd)

For the perfect competitor, price is also equal to average revenue (AR)
becauseThe demand curve is the average revenue curveAR = = = PTR Q PQ Q

20 Figure 23-2 Profit Maximization, Panel (a)

21 Figure 23-2 Profit Maximization, Panel (b)

TotalOutput/Sales/ Total Market Total Totalday Costs Price Revenue Profit0

$10 $5 $0 $10 10 8 5 1 1

22 Figure 23-2 Profit Maximization, Panel (c)

TotalOutput/Sales/ Market Marginal Marginalday Price Cost Revenue0 $51

52 53 54 55 56 57 58 59 510 511 5$5 $53 52 51 54 55 56 57 58 5

23 How Much Should the Perfect Competitor Produce? (cont'd)

Profit-Maximizing Rate of ProductionThe rate of production that maximizes

total profits, or the difference between total revenues and total costsAlso, the
rate of production at which marginal revenue equals marginal cost
24 Marginal Revenue change in TR MR = change in Q

Using Marginal Analysis to Determine the Profit-Maximizing Rate of

ProductionMarginal RevenueThe change in total revenues divided by the
change in outputMR =change in TRchange in Q

25 Marginal Cost change in TC MR = change in Q

Using Marginal Analysis to Determine the Profit-Maximizing Rate of

Production (cont’d)Marginal CostThe change in total cost divided by the
change in outputMR =change in TCchange in Q

26 Profit maximization occurs at the rate of output at which

Using Marginal Analysis to Determine the Profit-Maximizing Rate of

Production (cont'd)Profit maximization occurs at the rate of output at
whichmarginal revenue equals marginal costMR = MC

27 Short-Run ProfitsTo find out what our competitive individual secure

digital cards producer is making in terms of profits in the short run, we have
to determine the excess of price above average total cost

28 Short-Run Profits (cont'd)

From Figure 23-2 previously, if we have production and sales of seven

Titanium batteries, TR = $35, TC = $30, and profit = $5 per hour.Now we
take info from column 6 in panel (a) and add it to panel (c) to get Figure
23-3.

29 Figure 23-3 Measuring Total Profits

Profits are maximized where MR = MCThis occurs at Q = 7.5 units

30 Short-Run Profits (cont'd)

Graphical depiction of maximum profits and graphical depiction of minimum

lossesThe height of the rectangular box in the previous figure represents profits
per unitThe length represents the amount of units producedWhen we multiply
these two quantities, we get total economic profits
31 Short-Run Profits (cont'd)

Short-run average profits are determined by comparing ATC with P = MR =

AR at the profit-maximizing QIn the short run, the perfectly competitive firm
can make either economic profits or economic losses

32 Figure 23-4 Minimization of Short-Run Losses

Losses are minimized where MR = MCThis occurs at Q = 5.5 units

33 Short-Run Profits (cont’d)

We see in the previous Figure 23-4 that the marginal revenue (d2) curve is
intersected (from below) by the marginal cost curve at an output rate of 5
batteries per hourThe firm is clearly not making profits because average total
costs at that output rate are greater than the price of $3 per battery.The
losses are shown in the shaded area.

34 The Short-Run Break-Even Price and the Short-Run Shutdown Price

What do you think?Would you continue to produce if you were incurring a

loss?In the short run?In the long run?

35 The Short-Run Break-Even Price and the Short-Run Shutdown Price

(cont'd)
As long as the loss from staying in business is less than the loss from shutting
down, the firm will continue to produce.A firm goes out of business when the
owners sell its assets; a firm temporarily shuts down when it stops producing,
but is still in business.

36 The Short-Run Break-Even Price and the Short-Run Shutdown Price

(cont'd)
As long as the price per unit sold exceeds the average variable cost per unit
produced, the earnings of the firm’s owners will be higher if it continues to
produce in the short run than if it shuts down.

37 Short-Run Break-Even Price

The Short-Run Break-Even Price and the Short-Run Shutdown Price

(cont'd)Short-Run Break-Even PriceThe price at which a firm’s total revenues
equal its total costsAt the break-even price, the firm is just making a normal
rate of return on its capital investment (it’s covering its explicit and implicit
costs).Short-Run Shutdown PriceThe price that just covers average variable
costsIt occurs just below the intersection of the marginal cost curve and the
average variable cost curve.

38 Figure 23-5 Short-Run Break-Even and Shutdown Prices

39 The meaning of zero economic profits Question Answer

The Short-Run Break-Even Price and the Short-Run Shutdown Price

(cont'd)The meaning of zero economic profitsQuestionWhy produce if you are
not making a profit?AnswerDistinguish between economic profits and
accounting profitsRemember when economic profits are zero a firm can still
have positive accounting profits

40 Example: Why Firms Stubbornly Produced Aluminum in the Late 2000s

Between the summer of 2008 and the end of the winter of 2009, the market
clearing price of aluminum fell by more than 50 percent.Meanwhile, almost all
aluminum firms maintained their production operations until early in the
spring of 2009.They did so because, even though the equilibrium price fell
below the short-run break-even price, for several months the price remained
above the short-run shutdown price.

41 The Supply Curve for a Perfectly Competitive Industry

QuestionWhat does the short-run supply curve for the individual firm look
like?AnswerThe firm’s short-run supply curve in a competitive industry is its
marginal cost curve at and above the point of intersection with the average
variable cost curve

42 Figure 23-6 The Individual Firm’s Short-Run Supply Curve

Given the price, the quantity is determined where MC = MRShort-run supply

= MC above minimum AVC
43 The Supply Curve for a Perfectly Competitive Industry (cont'd)

The Industry Supply CurveThe locus of points showing the minimum prices at
which given quantities will be forthcomingAlso called the market supply curve

44 Figure 23-7 Deriving the Industry Supply Curve

45 The Supply Curve for a Perfectly Competitive Industry (cont'd)

Factors that influence the industry supply curve (determinants of

supply)Firm’s productivityFactor costs (wages, prices of raw materials)Taxes
and subsidiesNumber of sellers

46 Price Determination Under Perfect Competition

QuestionHow is the market, or “going,” price established in a competitive

market?AnswerThis price is established by the interaction of all the suppliers
(firms) and all the demanders (consumers)

47 Price Determination Under Perfect Competition (cont'd)

The competitive price is determined by the intersection of the market demand

curve and the market supply curveThe market supply curve is equal to the
horizontal summation of the supply curves of the individual firms

48 Figure 23-8 Industry Demand and Supply Curves and the Individual Firm

Demand Curve, Panel (a)

Pe is the pricethe firm must takePe and Qe determined by the interaction of
the industry S and market D

49 Figure 23-8 Industry Demand and Supply Curves and the Individual Firm

Demand Curve, Panel (b)

Given Pe, firm produces qe where MC = MRIf AC = AC1, break-evenIf AC =
AC2, lossesIf AC = AC3, economic profit

50 The Long-Run Industry Situation: Exit and Entry

Profits and losses act as signals for resources to enter an industry or to leave
an industry
51 The Long-Run Industry Situation: Exit and Entry (cont'd)

SignalsCompact ways of conveying to economic decision makers information

needed to make decisionsAn effective signal not only conveys information but
also provides the incentive to react appropriately

52 The Long-Run Industry Situation: Exit and Entry (cont'd)

Exit and entry of firmsEconomic profitsSignal resources to enter the

marketEconomic lossesSignal resources to exit the market

53 The Long-Run Industry Situation: Exit and Entry (cont'd)

Allocation of capital and market signalsPrice system allocates capital according

to the relative expected rates of return on alternative investments.Investors
and other suppliers of resources respond to market signals about their highest-
valued opportunities.

54 The Long-Run Industry Situation: Exit and Entry (cont'd)

Tendency toward equilibrium (note that firms are adjusting all of the time)At
break-even, resources will not enter or exit the marketIn competitive long-run
equilibrium, firms will make zero economic profits

55 The Long-Run Industry Situation: Exit and Entry (cont'd)

Long-Run Industry Supply CurveA market supply curve showing the

relationship between prices and quantities after firms have been allowed time
to enter or exit from an industry, depending on whether there have been
positive or negative economic profits

56 The Long-Run Industry Situation: Exit and Entry (cont'd)

Constant-Cost IndustryAn industry whose total output can be increased

without an increase in long-run per- unit costsIts long-run supply curve is
horizontal.

57 Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries, Panel (a)

58 The Long-Run Industry Situation: Exit and Entry (cont'd)

Increasing-Cost IndustryAn industry in which an increase in industry output is

accompanied by an increase in long- run per unit costsIts long-run industry
supply curve slopes upward

59 Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries, Panel (b)

60 The Long-Run Industry Situation: Exit and Entry (cont'd)

Decreasing-Cost IndustryAn industry in which an increase in industry output

leads to a reduction in long-run per-unit costsIts long-run industry supply
curve slopes downward.

61 Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries, Panel (c)

62 Long-Run EquilibriumIn the long run, the firm can change the scale of its

plant, adjusting its plant size in such a way that it has no further incentive to
change; it will do so until profits are maximizedIn the long run, a competitive
firm produces where price, marginal revenue, marginal cost, short-run
minimum average cost, and long-run minimum average cost are equal

63 Figure 23-10 Long-Run Firm Competitive Equilibrium

64 Why Not … eliminate economic profits entirely?

If companies were prohibited from earning more than zero economic profits,
entrepreneurs would have little incentive to try new ways of doing things in an
effort to reduce costs and gain profits.There would also be no incentive for new
firms to enter an industry experiencing growing demand.Thus, society benefits
from the market signals created when firms experience positive short-run
economic profits.

65 Competitive Pricing: Marginal Cost Pricing

A system of pricing in which the price charged is equal to the opportunity cost
to society of producing one more unit of the good or service in questionThe
opportunity cost is the marginal cost to society.

66 Competitive Pricing: Marginal Cost Pricing (cont'd)

Market FailureA situation in which an unrestrained market operation leads to

either too few or too many resources going to a specific economic activity

67 You Are There: The Coal Mining Industry Confronts a Changing Cost

Structure
In past decades, coal mining was a decreasing- cost industry and the market
clearing price of coal steadily declined relative to other goods and
services.Today, coal mining has become an increasing-cost industry as miners
have to dig deeper and move more earth to extract coals from aging mines.So,
in the long run, the equilibrium price will rise as the demand for coal increases.

68 Issues & Applications: A Higher Price Sets Off a New California Gold Rush

Since 2000, both the current dollar and the inflation-adjusted price of gold
have more than tripled.As the theory of perfect competition predicts, the
increase in the price of gold has touched off renewed interest by mining firms
in trying to extract gold from California mines abandoned decades ago.

69 Issues & Applications: A Higher Price Sets Off a New California Gold Rush

(cont’d)
The gold mining industry satisfies the key characteristics of perfect
competition:Units of each type of gold are homogeneous, even though it has
different qualitiesMany mining firms have the technology to extract gold from
earthThe potential output of each mining firm is small relative to total gold
productionIt is easy to enter or leave the industry

70 Figure 23-11 Index Measures of the Current-Dollar and

Inflation-Adjusted Prices of Gold

71 Summary Discussion of Learning Objectives

The characteristics of a perfectly competitive market structureLarge number

of buyers and sellersHomogeneous productBuyers and sellers have equal access
to informationNo barriers to entry and exit

72 Summary Discussion of Learning Objectives (cont'd)

How a perfectly competitive firm decides how much to produceEconomic

profits are maximized when marginal cost equals marginal revenue as long as
the market price is not below the short-run shutdown price, where the
marginal cost curve crosses the average variable cost curve

73 Summary Discussion of Learning Objectives (cont'd)

The short-run supply curve of a perfectly competitive firmThe rising part of

the marginal cost curve above minimum average variable costThe equilibrium
price in a perfectly competitive marketA price at which the total amount of
output supplied by all firms is equal to the total amount of output demanded
by all buyers

74 Summary Discussion of Learning Objectives (cont'd)

Incentives to enter or exit a perfectly competitive industryEconomic profits

induce entry of new firmsEconomic losses will induce firms to exit the industry

75 Summary Discussion of Learning Objectives (cont'd)

The long-run industry supply curve and constant-, increasing-, and

decreasing-cost industriesThe relationship between price and quantity after
firms have been able to enter or exit the industryConstant-cost
industryHorizontal long-run supply curveIncreasing-cost
industryUpward-sloping long-run supply curveDecreasing-cost
industryDownward-sloping long-run supply curve