Chapter 8

Perfect Competition

2006 Thomson/South-Western

Terminology
An industry consists of all firms that supply output to a particular market, interchangeable with market Many of the firms decisions depend on the structure of the market in which it operates Market structure describes the important features of a market
2

Market Structure
Number of suppliers Products degree of uniformity
Do firms

in the market supply identical products or are there differences across firms? enter easily or are they blocked by natural or artificial barriers? compete only through prices or are advertising and product differences common as well?
3

Ease of entry into the market

Can new firms

Forms of competition among firms

Do firms

Perfectly Competitive Market Structure

Many buyers and sellers Each buys and sells only a tiny fraction of the total amount exchanged in the market Standardized or homogeneous product Buyers and sellers are fully informed about the price and availability of all resources and products Firms and resources are freely mobile over time they can easily enter or leave the industry
4

Perfect Competition
Individual participants have no control over the price Price is determined by market supply and demand the perfectly competitive firm is a price taker it must take or accept, the market price Firm is free to produce whatever quantity maximizes profit

Exhibit 1: Market Equilibrium and the Firms Demand Curve in Perfect Competition
Market price of wheat of $5 per bushel is determined in the left panel by the intersection of the market demand curve and the market supply curve. Once the market price is established, farmer can sell all he or she wants at that market price price taker

(a) Market Equilibrium

Price per bushel Price per bushel S

(b) Firms Demand

$5

$5

D 0 1,200,000 Bushels of wheat per day 0 5 10 15 Bushels of wheat per day

Total Revenue Minus Total Cost

The firm maximizes economic profit by finding the rate of output at which total revenue exceeds total cost by the greatest amount Total revenue is simply output times the price per unit Exhibits 2 and 3 provide us with the needed information
7

Exhibit 2: Short-Run Costs and Revenues

(1) (2) (3) = (1) (2) (4) Bushels of Marginal Wheat Revenue Total Total per day (Price) Revenue Cost (q) (p) (TR = q p) (TC) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 -$5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 $0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 $15.00 19.75 23.50 26.50 29.00 31.00 32.50 33.75 35.25 37.25 40.00 43.25 48.00 54.50 64.00 77.50 96.00

(5) (6) = (4) + (1) (7) = (3) - (4) Marginal Average Economic Cost Total Cost Profit or MC=TC/ Q ATC = TC / q Loss = TR - TC -$4.75 3.75 3.00 2.50 2.00 1.50 1.25 1.50 2.00 2.75 3.25 4.75 6.50 9.50 13.50 18.50 $19.75 11.75 8.83 7.25 6.20 5.42 4.82 4.41 4.14 4.00 3.93 4.00 4.19 4.57 5.17 6.00 -$15.00 -14.75 -13.50 -11.50 -9.00 -6.00 -2.50 1.25 4.75 7.75 10.00 11.75 12.00 10.50 6.00 -2.50 -16.00

Exhibit 3: Short-Run Profit Maximization

(a) Total Revenue Minus Total Cost At output less than 7 bushels and greater than 14 bushels, total cost exceeds total revenue economic loss measured by the vertical distance between the two curves Total revenue exceeds total cost between 7 and 14 bushels per day economic profit is maximized at the rate of 12 bushels of wheat per day
Total revenue (= $5 q ) Total dollars $60 48 Total cost Maximum economic profit = $12

15

10

12

15

Bushels of wheat per day

Marginal Revenue Equals Marginal Cost

Marginal revenue, MR, is the change in total revenue from selling another unit of output Since the firm in perfect competition is a price taker, marginal revenue from selling one more unit is the market price MR = P Marginal cost is the change in total cost resulting from producing another unit of output

10

Exhibit 2: Short-Run Costs and Revenues

(1) (2) (3) = (1) (2) (4) Bushels of Marginal Wheat Revenue Total Total per day (Price) Revenue Cost (q) (p) (TR = q p) (TC) 0 1 2 3 4 5 6 7 8 9 10 11 -$5 5 5 5 5 5 5 5 5 5 5 $0 5 10 15 20 25 30 35 40 45 50 55 $15.00 19.75 23.50 26.50 29.00 31.00 32.50 33.75 35.25 37.25 40.00 43.25 (5) (6) = (4) + (1) (7) = (3) - (4) Marginal Average Economic Cost Total Cost Profit or MC=TC/ Q ATC = TC / q Loss = TR - TC -$4.75 3.75 3.00 2.50 2.00 1.50 1.25 1.50 2.00 2.75 3.25

The firm will increase quantity supplied as long as each additional unit adds more to total revenue that to total cost as long as MR exceeds MC MR exceeds MC for the first 12 bushels Profit maximizer will limit output to 12 bushels per day

$19.75 11.75 8.83 7.25 6.20 5.42 4.82 4.41 4.14 4.00 3.93

-$15.00 -14.75 -13.50 -11.50 -9.00 -6.00 -2.50 1.25 4.75 7.75 10.00 11.75

12
13 14 15 16

5
5 5 5 5

60
65 70 75 80

48.00
54.50 64.00 77.50 96.00

4.75
6.50 9.50 13.50 18.50

4.00
4.19 4.57 5.17 6.00

12.00
10.50 6.00 -2.50 -16.00

11

Exhibit 3b: Short-Run Profit Maximization

(b) Marginal Cost Equals Marginal Revenue

The MC curve intersects the MR curve at point e, where output is 12 bushels per day At rates of output less than 12 bushels, MR > MC firm can increase profit by expanding output At higher rates of output MC > MR firm can increase profits by reducing output Profit appears in the blue shaded rectangle and equals the price of $5 minus the average cost of $4, or $1 per bushel

Marginal cost Average total cost Dollars per unit e Profit

4

$5

d = Marginal revenue = average revenue a

10

12

15

Bushels of wheat 12 per day

Marginal Revenue Equals Marginal Cost

Golden rule of profit maximization: Generally, a firm will expand output as long as marginal revenue exceeds marginal cost and will stop expanding output before marginal cost exceeds marginal revenue

13

Economic Profit in the Short Run

Because the perfectly competitive firm can sell any quantity for the same price per unit, marginal revenue is also average revenue
Average revenue,

AR, equals total revenue divided by quantity AR = TR / q

Regardless of the rate of output, the following equality holds along the firms demand curve
Market price = marginal revenue = average

revenue
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Minimizing Short-Run Losses

Sometimes the price that the firm is required to take will be so low that no rate of output will yield an economic profit Faced with losses at all rates of output, the firm has two options
It

can continue to produce at a loss, or Temporarily shut down It cannot shut down in the short run because by definition the short run is a period too short to allow existing firms to leave or new firms to enter
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Exhibit 4: Minimizing Losses

(1) (2) (3) = (1) (2) (4) Bushels of Marginal Wheat Revenue Total Total per day (Price) Revenue Cost (q) (p) (TR = q p) (TC) 0 1 2 3 4 5 6 7 8 9 -$3 3 3 3 3 3 3 3 3 $0 3 6 9 12 15 18 21 24 27 $15.00 19.75 23.50 26.50 29.00 31.00 32.50 33.75 35.25 37.25 (7) Average Marginal Average Variable Cost Total Cost Cost MC=TC/Q ATC = TC /q AVC = TVC / q -$4.75 3.75 3.00 2.50 2.00 1.50 1.25 1.50 2.00

(5)

(6) = (4) + (1)

(8) = (3) - (4) Economic Profit or Loss = TR - TC -$15.00 -16.75 -17.50 -17.50 -17.00 -16.00 -14.50 -12.75 -11.25 -10.25

$19.75 11.75 8.83 7.25 6.20 5.42 4.82 4.41 4.14

-$4.75 4.25 3.83 3.50 3.20 2.92 2.68 2.53 2.47

10
11 12 13 14 15 16 3 3 3 3 3 3

30
33 36 39 42 45 48

40.00
43.25 48.00 54.50 64.00 77.50 96.00

2.75
3.25 4.75 6.50 9.50 13.50 18.50

4.00
3.93 4.00 4.19 4.57 5.17 6.00

2.50
2.57 2.75 3.04 3.50 4.17 5.06

-10.00
-10.25 -12.00 -15.50 -22.00 -32.50 -48.00

Marginal revenue exceeds marginal cost for the first 12 bushels of wheat. Because of the lower price, total revenue is lower at all rates of output and economic profit has disappeared column (8) Column (8) indicates that the firms loss is minimized at $10 per day when 10 bushels are produced the net gain of $5 total cost. Exhibit 5 illustrates this same conclusion graphically 16

Exhibit 5: Minimizing Short-Run Losses

In panel (a), Total revenue is lower because of the lower price Total revenue now lies below the total cost curve at all output rates. The vertical distance between the two curves measures the loss at each rate of output The vertical distance is minimized at an output rate of 10 bushels where the loss is $10 per day Same result in panel b Firm will produce rather than shut down if MR = MC at a rate of output where price equals or exceeds average variable cost At point e, output is 10 bushels per day and the price of $3 exceeds the average variable cost of $2.50 Total economic loss shown by shaded area
(a) Total Cost and Total Revenue Total cost Total revenue (= $3 q )
Total dollars

$40 30 15 0 5 10 Minimum economic loss = $10 15

Bushels of wheat per day

b) Marginal Cost Equals Marginal Revenue

Dollars per bushel

Marginal cost Average total cost $4.00 3.00 2.50 Average variable cost d = Marginal revenue = average revenue

Loss

10

15

Bushels of wheat per day

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Shutting Down in the Short Run

As long as the loss that results from producing is less than the shutdown loss, the firm will remain open for business in the short run
If

the average variable cost of production exceeds the price of all rates of output, the firm will shut down

A re-examination of previous exhibit indicates that if the price of wheat were to fall to $2 per bushel, average variable cost exceeds $2 at all rates of output

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Shutting Down in the Short Run

Shutting down is not the same as going out of business In the short run, even a firm that shuts down keeps its productive capacity intact that when demand increases enough, the firm will resume operation If market conditions look grim and are not expected to increase, the firm may decide to leave the market a long run decision
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Exhibit 6: Summary of Short-Run Output Decisions

At p1, the firm will shut down rather than operate because price is below average variable cost at all output rates. If the price is p3, the firm will produce q3 to minimize its loss while at p4, the firm will produce q4 to earn just a normal profit: breakeven point At p2, the firm is indifferent: shutdown point If the price rises to p5, the firm will earn a short-run economic profit by producing q5 Marginal cost Break-even point Dollars per unit p5 p4 p3 p2 p1 Shutdown point 0 q1 1 2 4 3 Average variable cost 5 Average total cost d5 d4 d3 d2 d1 The short-run supply curve is the upward-sloping portion of the marginal cost curve beginning at point 2. q2 q3 q4 q5 Quantity per period
20

Short-Run Firm Supply Curve

As long as the price covers average variable cost, the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve Thus, that portion of the firms marginal cost curve that intersects and rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve
21

Exhibit 7: Aggregating Individual Supply to Form Market Supply

(a) Firm A
Price per unit SA p' p p' p

(b) Firm B
SB p' p

(c) Firm C
SC p' p

(d) Industry, or market, supply

SASBSC S

10

20

10 20

10 20
Quantity per period

30

60

Quantity per period

Quantity per period

Quantity per period

At a price below p, no output is supplied At a price of p, each firm supplies 10 units: a market supply of 30 units At a price of p', each firm supplies 20 units: a market supply of 60 units The short-run industry supply curve is the horizontal sum of all firms short-run supply curves: horizontal summation of the firm level marginal cost curves
22

Exhibit 8: Relationship Between Short-Run Profit Maximization and Market Equilibrium

(a) Firm
Price per unit

(b) Industry, or market

MC = S

MC = s
ATC AVC Profit

$5 4

$5 D

10 12

Bushels of wheat per day

1,200,000

Bushels of wheat per day

If there are 100,000 identical wheat farmers, their individual supply curves are summed horizontally to yield the market supply curve, panel b, where market price of $5 is determined. At this price, each farmer produces 12 bushels per day, as in panel a, for a total quantity supplied of 1,200,000 bushels per day 23 Each farmer earns an economic profit of $12 per day as shown by the shaded rectangle.

Perfect Competition in Long Run

Firms have time to enter and exit and to adjust their scale of their operations: there is no distinction between fixed and variable cost because all resources under the firms control are variable Short-run economic profit will in the long run encourage new firms to enter the market and may prompt existing firms to expand the scale of their operations: the industry supply curve shifts rightward in the long run, driving down the price New firms will continue to enter a profitable industry and existing firms will continue to increase in size as long as economic profit is greater than zero
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Exhibit 9: Long Run Equilibrium for the Firm and the Industry

(a) Firm
MC Dollars per unit Price per unit ATC LRAC p e d

(b) Industry, or market

S

p D

Quantity per period

Quantity per period

In the long run, market supply adjusts as firms enter or leave, or change their size. This process continues until the market supply intersects the market demand at a price that equals the lowest point on each firms long-run average cost curve, at point e with each firm producing q units. At point e, marginal cost, short-run average 25 total cost and long-run average cost are all equal.

Exhibit 10: Long-Run Adjustment to an Increase in Demand

(a) Firm
MC
Dollars per unit Price per unit

(b) Industry, or Market

S S'

p'

Profit
p

d' ATC LRAC d

p' a p

b c

S* D'

D 0

q'

Quantity per period

Qa

Qb Qc

Quantity per period

Initial point of equilibrium is a in panel b: individual firm supplies q units and earns a normal profit Suppose market demand increases from D to D': market price increases in short run to p' Firms respond by expanding output along the short-run supply curve quantity supplied increases to q: economic profits attract new firms, market supply curve shifts to S' where it intersects D' at point c: price returns to initial equilibrium level Demand curve facing the individual firm shifts back down from d' to d 26

Exhibit 11: Long-Run Adjustment to a Decrease in Demand

(a) Firm (b) Industry, or Market
S" ATC LRAC p Loss p" d" e d Price per unit S

MC Dollars per unit

g p p" f

S* D

D" 0 q" q
Quantity per period

Qg

Qf

Qa

Quantity per period

Initial long-run equilibrium shown by point a in the market and e for the firm Market demand declines from D to D market price falls to p demand curve facing each firm drops to d firm responds by reducing its output to q and market output falls to Qf: each firm faces a loss In the long run some firms go out of business: market supply will decrease from S to S" price increases back to p and the new market equilibrium is shown by point g. Market output has fallen to Qg and the remaining firms are just earning a normal profit as demand shifts back to d. 27

Long-Run Industry Supply Curve

Beginning at an initial long-run equilibrium point, with demand shifting, we found two more long-run equilibrium points Connecting these long-run equilibrium points yields the long-run industry supply curve, labeled S* in both of these exhibits Shows the relationship between price and quantity supplied once firms fully adjust to any short-term economic profit or loss resulting from a shift in demand
28

Constant-Cost Industry
Firms long-run average cost curve does not shift as industry output expands

Resource prices and other production costs remain constant in the long run as industry output increases or decreases

Each firms per-unit production costs are independent of the number of firms in the industry: the firms longrun average cost curve remains constant in the long run as firms enter or leave the industry

The industry uses such a small portion of the resources available that increasing industry output does not bid up resource prices

The long-run supply curve for a constant-cost industry is horizontal

29

Increasing-Cost Industry
Firms in some industries encounter higher average costs as industry output expands in the long run Firms in these increasing-cost industries find that expanding output bids up the prices of some resources or otherwise increases per-unit production costs: each firms cost curves shift upward
30

Exhibit 12: An Increasing-Cost Industry

(a) Firm (b) Industry, or Market

MC Dollars per unit ATC Price per unit

pa

da

D
0 q Quantity per period 0 Qa Quantity per period

The initial position of equilibrium is shown at point a, where the initial market demand and supply curves are D and S - the market price is pa and the market quantity Qa the demand and marginal revenue curve facing each firm is da the firm produces q, average total cost is at a minimum: firm earns no economic profit in this long31 run equilibrium

Exhibit 12: An Increasing-Cost Industry

(a) Firm (b) Industry, or Market

MC Dollars per unit ATC Price per unit

pb b db pb

S
b

D'
p
a

pa

da

D
0

qb

0
Quantity per period

Qa

QbQuantity per

period

Increase in market demand is shown by the shift from D to D, which intersects the short-run market supply curve S at point b: short-run equilibrium price pb and market quantity Qb each firms demand curve shifts from da up to db b in the left panel where the marginal cost curve intersects the new demand curve each firm produces qb: economic profit equal to qb times the difference between the pb and the average total cost at that 32

Exhibit 12: An Increasing-Cost Industry

(a) Firm
MC' S MC Dollars per unit Price per unit pb pc pa b ATC' c db ATC dc da pb pc p a D 0 q qb Quantity per period 0 Quantity per period b S'

(b) Industry, or Market

c D'

Qa

Qb Qc

The existence of economic profit attracts new entrants but because this is an increasing-cost industry, new entrants increased demand for resources drives up the costs of production and raises each firms marginal and average cost curves. In the left panel, MC and ATC shift up to MC' and ATC'. The entry of the new firms also shifts the short-run industry supply curve outward from S to S' decline in the market price from b to c.
33

Exhibit 12: An Increasing-Cost Industry

(a) Firm
MC' S

(b) Industry, or Market

MC
Dollars per unit ATC' c Price per unit pb pc pa b db ATC dc da pb pc p
a

S' b S* c D' a D

qb

Quantity per period

Qa

Qb Qc

Quantity per period

A combination of a higher production cost and a lower price squeezes economic profit to zero: S'. Market price does not fall back to initial equilibrium level because each firms ATC shifted up with the expansion of industry output. New long-run market equilibrium occurs at point c, and when points a and c are connected, we get the 34 upward sloping long-run market supply curve shown as S*

Perfect Competition and Efficiency

There are two concepts of efficiency used to judge market performance
Productive

efficiency refers to producing output at the least possible cost Allocative efficiency refers to producing the output that consumers value the most Perfect competition guarantees both allocative and productive efficiency in the long run
35

Productive Efficiency: Making Stuff Right

Productive efficiency occurs when the firm produces at the minimum point on its long-run average-cost curve the market price equals the minimum average total cost The entry and exit of firms and any adjustment in the scale of each firm ensure that each firm produces at the minimum point on its long-run average cost curve
36

Allocative Efficiency: Making the Right Stuff

Occurs when firms produce the output that is most valued by consumers The demand curve reflects the marginal value that consumers attach to each unit
the market

price is the amount of money that people are willing and able to pay for the final unit they consume

In both the short run and the long run, the equilibrium price in perfect competition equals the marginal cost of supplying the last unit sold
37

Allocative Efficiency
Marginal cost measures the opportunity cost of all resources employed by the firm to produce the last unit sold Supply and demand curves intersect at the combination of price and quantity at which the marginal value, benefit that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit There is no way to reallocate resources to increase the total utility consumers reap from production
38

Whats So Perfect About Perfect Competition?

Market exchange benefits both consumers and producers

Recall

that consumers garner a surplus from market exchange because the maximum amount they would be willing to pay for each unit of the good exceeds the amount they in fact pay

39

Exhibit 13: Consumer Surplus and Producer Surplus

Consumer surplus is the area below the demand curve but above the market clearing price of $10 Producers also derive a net surplus from market exchange because the amount they receive for their output exceeds the minimum amount they would require to supply the amount The short-run market supply curve is the sum of that portion of each firms marginal cost curve at or above the minimum point on its average variable cost, point m on the market supply curve S
Dollars per unit

Consumer surplus
$10 e

Producer surplus 5

m
Quantity per period

100,000 120,000

200,000
40

Exhibit 13: Consumer Surplus and Producer Surplus

If price increases from $5 to $6, firms increase quantity supplied until marginal cost equals $6: output increases from 100,000 to 120,000 and total revenue increases from $500,000 to $720,000. In the short run, producer surplus is total revenue minus variable cost of production. Market clearing price is $10 Productive and allocative efficiency in the short run occurs at point e.

Dollars per unit

Consumer surplus
$10

S e

6 5

Producer surplus m

100,000 120,000

200,000

Quantity per period 41

Producer Surplus
Not the same as economic profit Any price that exceeds average variable cost will result in a short-run producer surplus, even though that price could result in a shortrun economic loss Ignores fixed cost, because fixed cost is irrelevant to the firms short-run production decision
42