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

Horizontal!• When the

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 competitive firm, P=MR. Also, the firm maximizes profits or minimizes losses by producing that quantity of output at which MR=MC.

Because P=MR and MR=MC, it follows that P=MC, that is the perfectly competitive firm exhibits resource allocative efficiency.

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 farmers, Cordero earns profits and Hancock does not. Cordero earns profits because the land he farms is of 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.

This moves Cordero’s ATC curve upward to the same level as Hancock’s, and Cordero earns zero economic profits. The profits have gone as payment (implicit or explicit) for the higher-quality, more productive land.

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 higher prices?

• A rise in costs incurred by one of many firms does not mean consumers will pay higher prices

• Will the perfectly competitive firm advertise?

• What are the costs and what are the benefits of advertising?

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?