8

The Firm and the Industry

Under Perfect Competition
Competition . . . brings about the only . . . arrangement of social
production which is possible. . . . [Otherwise] what guarantee [do] we
have that the necessary quantity and not more of each product will be
produced, that we shall not go hungry in regard to corn and meat while
we are choked in beet sugar and drowned in potato spirit, that we shall
not lack trousers to cover our nakedness while buttons flood us in
millions?
FRIEDRICH ENGELS (THE FRIEND AND CO-AUTHOR OF KARL MARX)
Contents

● Perfect Competition Defined

● The Competitive Firm
● The Competitive Industry
● Perfect Competition and Economic
Efficiency

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 Perfect Competition Defined

● Four Principal Market Types

♦ Perfect competition
♦ Monopolistic competition
♦ Oligopoly
♦ Pure monopoly

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 Perfect Competition Defined

● Perfect competition
♦ Many small firms and customers
♦ Homogeneous product
♦ Free entry and exit
♦ Well-informed producers and consumers

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 The Competitive Firm

● Perfect competition
♦ Firm is a price taker.
♦ Price is set in the market.
♦ Firm is too small to affect the market.

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 The Competitive Firm

● The Firm’s Demand Curve under Perfect

Competition
♦ Horizontal
♦ Can sell as much as it wants at the market
price.

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 FIGURE8-1 Demand Curve for a
Firm under Perfect Competition
D Industry S
supply
curve
Price per Bushel

A B C E Industry
$3 $3 demand
in Chicago

curve
Firm’s demand
curve
S
D
0 1 2 3 4 0 100 200 300 400
Truckloads of Corn Total Sales in Chicago
Sold by Farmer Jasmine in Thousands of Truckloads
per Year per Year
(a) (b)

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 The Competitive Firm

● Short-Run Equilibrium for the Perfectly

Competitive Firm
♦ Marginal revenue = price
♦ Profit-maximizing level of output: marginal
cost = price
♦ MC = MR

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 TABLE 8-1 Revenues, Costs, and
Profits of a Competitive Firm

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 The Competitive Firm

● D = MR = AR at all levels of output

● Short-Run
D = MR = Equilibrium
AR = MC at the equilibrium
level of output

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 FIGURE8-2 S-R Equilibrium of
the Competitive Firm
Revenue and Cost per Bushel

MC AC

B
$3.00
D = MR = AR
2.25
A
1.50

0 50,000

Bushels of Corn per Year

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Short-Run Profit: Graphic
Representation
● The MC = P condition does not show if the
firm is making a profit or incurring a loss.
● Compare price (average revenue) with
average cost to calculate profit or loss per
unit.
● The profit-maximizing output may lead to a
loss, but if so it is the minimum possible
loss.
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 FIGURE8-3 S-R Equilibrium of
Competitive Firm w/Lower Price

MC AC
Revenue and Cost
per Bushel

A
$2.25

1.50
B D = MR = P

0 30,000

Bushels of Corn per Year

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Short-Run Profit: Graphic
Representation
● The MC = P condition does not show if the
firm is making a profit or incurring a loss.
● Compare price (average revenue) with
average cost to calculate profit or loss per
unit.
● The profit-maximizing output may lead to a
loss, but if so it is the minimum possible
loss.
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Shutdown and Break-Even
Analysis
● Rule 1: The firm will make a profit if total
revenue (TR) > total cost (TC)
● Should not plan to shut down in either the
short run or the long run.

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Shutdown and Breakeven
Analysis
● Rule 2: Even if TR < TC, the firm should
continue to operate in the short run as long
as TR > TVC.
● If TR > TVC, the firm can at least pay some
of its fixed costs.
● The firm should close in the long run if TR
< TC.

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 TABLE 8-2 The Shutdown
Decision

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Shutdown and Breakeven
Analysis
● The competitive firm will produce nothing
unless price lies above the minimum point
on the AVC curve.

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FIGURE 8-4 Shutdown Analysis

MC
AC AVC

P3 P3
A
B
Price

P2 P2

P1 P1

0
Quantity Supplied

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The Competitive Firm’s Short-run
Supply Curve
● Horizontal  individual supply curves 
market supply curve
● Method analogous to the construction of a
market demand curve from individual
demand curves.

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 8-5 Derivation of the
FIGURE
Industry Supply Curve
s S
Price per Bushel

Price per Bushel

e E
$3.00 $3.00
c C
2.25 2.25

s S

45 50 45 50
Quantity Supplied in Quantity Supplied in
Thousands of Bushels Millions of Bushels
(a) (b)

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 The Competitive Industry

● The Competitive Industry’s Short-Run

Supply Curve
♦ A competitive industry has a stable equilibrium
at the output where supply equals demand.
♦ The competitive industry (unlike the
competitive firm) faces a downward sloping
demand curve.

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 FIGURE 8-6 Supply-Demand
Equil. of a Competitive Industry
S

D
Price per Bushel

$3.75
E
3.00
C A
2.25
D
S

0 45 50 72

Quantity of Corn in
Millions of Bushels

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 The Competitive Industry

● Industry Equilibrium in the Short Run

♦ Economic costs include opportunity costs, so
zero economic profit means that firms are
earning the normal, economy-wide rate of
profit.
♦ Freedom of entry and exit guarantee this result
in the long run under perfect competition.

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 The Competitive Industry

● Industry and Firm Equilibrium in the Long

Run
♦ In the long run, firms enter or exit the industry
in response to profits or losses.
♦ This shifts the supply curve and the price until
profits are zero.
♦ In long-run, competitive equilibrium, P = MC =
AC.

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 FIGURE8-7 A Shift in the Industry
Supply Curve
(1,000 firms)
S0 (1,600 firms)
S1
D
Price per Bushel

E F
$3.00
A
2.25

S1 D
S0

50 72 80

Quantity of Corn in
Millions of Bushels

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 8-8 The Competitive Firm
FIGURE
and the Competitive Industry

Firm Industry
MC (1,000 firms)
AC S0
Price per Bushel

Price per Bushel

D
(1,600 firms)
S1
e E
$3.00 D0 $3.00
a A
2.25 D1 2.25
b S0 D
S1

40 45 50 50 72
Quantity of Corn in Quantity of Corn in
Thousands of Bushels Millions of Bushels
(a) (b)

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 8-9 L-R Equilibrium of the
FIGURE
Competitive Firm and Industry
Firm Industry
MC

D
Price per Bushel

Price per Bushel

AC
(2,075 firms)
S2
m M
$1.87 D2 $1.87
S2
D

40 83
Quantity of Corn in Quantity of Corn in
Thousands of Bushels Millions of Bushels
(a) (b)

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 The Competitive Industry

● The Long-Run Industry Supply Curve

■The long-run supply curve of the competitive
industry is also the industry’s long-run average cost
curve.
■The industry is driven to that supply curve by the
entry or exit of firms and by the adjustment of
firms already in the industry.

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 FIGURE 8-10 S-R Industry Supply
and L-R Industry Average Cost
Price, Average Cost per Bushel

B LRAC
$2.62

S
1.50 A

0 70

Output in
Millions of Bushels of Corn

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 Perfect Competition and
Economic Efficiency
● In the long run, competitive firms are driven
to produce at the minimum point of their
average cost curves.
● In this case, output is produced at the lowest
possible cost to society.

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 TABLE 8-3 Avg. Cost for the Firm
and Total Cost for the Industry

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 Which is Better to Cut
? Pollution: Carrot or Stick?
● The analysis of perfect competition can be
used to show that, if firms are offered a
subsidy to reduce their polluting emissions,
the industry is likely to increase its
emissions, because of free entry.

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 FIGURE 8-11 Taxes vs Subsidies
as Incentives to Cut Pollution
T
D
Price, Average Cost

X
B
E S
A
T
D
X

0 Qb Qe Qa

Output

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