Download - CHAPTER 12 Perfect Competition
CHAPTER 12
Perfect CompetitionCHAPTER 12
Perfect Competition
Michael ParkinECONOMICS 5e
TM 12-2Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define perfect competition
• Explain how price and output are determined in a competitive industry
• Explain why firms sometimes shut down temporarily and lay off workers
TM 12-3Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Explain why firms enter and leave an industry
• Predict the effects of a change in demand and of a technological advance
• Explain why perfect competition is efficient
TM 12-4Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define perfect competition
• Explain how price and output are determined in a competitive industry
• Explain why firms sometimes shut down temporarily and lay off workers
TM 12-5Copyright © 1998 Addison Wesley Longman, Inc.
Perfect Competition
Characteristics of Perfect Competition
• Many firms, each selling an identical product.
• Many buyers.
• No restrictions on entry into the industry.
TM 12-6Copyright © 1998 Addison Wesley Longman, Inc.
Perfect Competition
Characteristics of Perfect Competition
• Firms in the industry have no advantage over
potential new entrants.
• Firms and buyers are well informed about
prices of the products of each firm in the
industry.
TM 12-7Copyright © 1998 Addison Wesley Longman, Inc.
Perfect Competition
As a result of these characteristics, perfect competitors are price takers.
Price takers
Firms that cannot influence the price of a good or service.
TM 12-8Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define perfect competition
• Explain how price and output are determined in a competitive industry
• Explain why firms sometimes shut down temporarily and lay off workers
TM 12-9Copyright © 1998 Addison Wesley Longman, Inc.
Economic Profit and Revenue
The firm’s goal is to maximize economic profit.
Total cost is the opportunity cost - including normal profit.
TM 12-10Copyright © 1998 Addison Wesley Longman, Inc.
Economic Profit and Revenue
Total revenue is the value of a firm’s sales.
• Total revenue = P Q
Marginal revenue (MR) • Change in total revenue resulting from a one-unit
increase in quantity sold.
Average revenue (AR)
• Total revenue divided by the quantity sold—revenue per unit sold.
In perfect competition, Price = MR = AR
TM 12-11Copyright © 1998 Addison Wesley Longman, Inc.
Economic Profit and Revenue
Suppose Sidney sells his sweaters
in a perfectly competitive market.
TM 12-12Copyright © 1998 Addison Wesley Longman, Inc.
Demand, Price, and Revenuein Perfect Competition
Quantity Price Marginal Average
sold (P) Total revenue revenue (Q) (dollars revenue (AR = TR/Q
(sweaters per TR = P Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)
8 25
9 25
10 25
QTRMR /
TM 12-13Copyright © 1998 Addison Wesley Longman, Inc.
Demand, Price, and Revenuein Perfect Competition
Quantity Price Marginal Average
sold (P) Total revenue revenue (Q) (dollars revenue (AR = TR/Q
(sweaters per TR = P Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)
8 25 200
9 25 225
10 25 250
QTRMR /
TM 12-14Copyright © 1998 Addison Wesley Longman, Inc.
Demand, Price, and Revenuein Perfect Competition
Quantity Price Marginal Average
sold (P) Total revenue revenue (Q) (dollars revenue (AR = TR/Q
(sweaters per TR = P Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)
8 25 200
9 25 225
10 25 250
QTRMR /
25
25
TM 12-15Copyright © 1998 Addison Wesley Longman, Inc.
Demand, Price, and Revenuein Perfect Competition
Quantity Price Marginal Average
sold (P) Total revenue revenue (Q) (dollars revenue (AR = TR/Q
(sweaters per TR = P Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)
8 25 200 25
9 25 225 25
10 25 250 25
QTRMR /
25
25
TM 12-16Copyright © 1998 Addison Wesley Longman, Inc.
TR
D
S
Demand, Price, and Revenuein Perfect Competition
Quantity (thousandsof sweaters per day)
Quantity (sweaters per day) Quantity (sweaters per day)
Pri
ce (
doll
ars
per
swea
ter)
Pri
ce (
doll
ars
per
swea
ter)
Tot
al r
even
ue (
doll
ar p
er d
ay)
0 9 20 0 10 20 0 9 20
25
50
25 225
50
MR aMarketdemandcurve
Sweater marketSidney’s demandand marginal revenue Sidney’s total revenue
Sidney’sdemandcurve
TM 12-17Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define perfect competition
• Explain how price and output are determined in a competitive industry
• Explain why firms sometimes shut down temporarily and lay off workers
TM 12-18Copyright © 1998 Addison Wesley Longman, Inc.
The Firm’s Decisions inPerfect Competition
A firm’s task is to make the maximum economic profit possible, given the constraints it faces.
In order to do so, the firm must make two decisions in the short-run, and two in the long-run.
TM 12-19Copyright © 1998 Addison Wesley Longman, Inc.
The Firm’s Decisions inPerfect Competition
Short-run A time frame in which each firm has a given plant and the number of firms in the industry is fixed
Long-run A time frame in which each firm can change the size of its plant and decide to enter the industry.
TM 12-20Copyright © 1998 Addison Wesley Longman, Inc.
The Firm’s Decisions inPerfect Competition
In the short-run, the firm must decide:
• Whether to produce or to shut down.
• If the decision is to produce, what quantity to produce.
TM 12-21Copyright © 1998 Addison Wesley Longman, Inc.
The Firm’s Decisions inPerfect Competition
In the long-run, the firm must decide:
• Whether to increase of decrease its plant size.
• Whether to stay in the industry or leave it.
We will first address the short-run.
TM 12-22Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue, Total Cost, and Economic Profit
Quantity Total Total Economic (Q) revenue cost profit (sweaters (TR) (TC) (TR – TC)
Per day) (dollars) (dollars) (dollars)
0 01 252 503 754 1005 1256 1507 1758 2009 22510 25011 27512 30013 325
TM 12-23Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue, Total Cost,and Economic Profit
Quantity Total Total Economic (Q) revenue cost profit (sweaters (TR) (TC) (TR – TC)
Per day) (dollars) (dollars) (dollars)
0 0 221 25 452 50 663 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360
TM 12-24Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue, Total Cost,and Economic Profit
Quantity Total Total Economic (Q) revenue cost profit (sweaters (TR) (TC) (TR – TC)
Per day) (dollars) (dollars) (dollars)
0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 248 200 160 409 225 183 4210 250 210 4011 275 245 3012 300 300 013 325 360 -35
TM 12-25Copyright © 1998 Addison Wesley Longman, Inc.
TC
Total Revenue, Total Cost,and Economic Profit
Quantity (sweaters per day)
Tot
al r
even
ue &
tota
l cos
t (
doll
ars
per
day)
0 4 9 12
100
300
183
225
TR
Economicloss
Economicprofit =TR - TC
Economicloss
TM 12-26Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue, Total Cost,and Economic Profit
Quantity (sweaters per day)
4 9 12-20
0
-40
42
20
Profitmaximizing quantity
Profit/loss
Economicprofit
Economicloss
Prof
it/l
oss
(do
llar
s pe
r da
y)
Economic profit/loss
TM 12-27Copyright © 1998 Addison Wesley Longman, Inc.
Marginal Analysis
Using marginal analysis, a comparison is made between a units marginal revenue and marginal cost.
TM 12-28Copyright © 1998 Addison Wesley Longman, Inc.
Marginal Analysis
If MR > MC, the extra revenue from selling one more unit exceeds the extra cost.
• The firm should increase output to increase profit.
If MR < MC, the extra revenue from selling one more unit is less than the extra cost.
• The firm should decrease output to increase profit.
If MR = MC economic profit is maximized.
TM 12-29Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Marginal Marginal revenue cost
Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)
7 175
8 200
9 225
10 250
11 275
TM 12-30Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Marginal Marginal revenue cost
Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)
7 175
8 200
9 225
10 250
11 275
25
25
25
25
TM 12-31Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Marginal Marginal revenue cost
Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)
7 175 141
8 200 160
9 225 183
10 250 210
11 275 245
25
25
25
25
TM 12-32Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Marginal Marginal revenue cost
Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)
7 175 141
8 200 160
9 225 183
10 250 210
11 275 245
25
25
25
25
19
23
27
35
TM 12-33Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Marginal Marginal revenue cost
Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)
7 175 141 34
8 200 160 40
9 225 183 42
10 250 210 40
11 275 245 30
25
25
25
25
19
23
27
35
TM 12-34Copyright © 1998 Addison Wesley Longman, Inc.
Profit-Maximizing Output
Quantity (sweaters per day) 8 9 10
10
20
30
Mar
gina
l rev
enue
& m
argi
nal c
ost
(do
llar
s pe
r da
y)
MR25
MCProfit-maximizationpoint
Loss from10th sweater
Profit from9th sweater
0
TM 12-35Copyright © 1998 Addison Wesley Longman, Inc.
The Firm’s Short-Run Supply Curve
Fixed costs must be paid in the short-run.
Variable-costs can be avoided by laying off workers and shutting down.
Firms shut down if price falls below the minimum of average variable cost.
TM 12-36Copyright © 1998 Addison Wesley Longman, Inc.
MR2
MR1
A Firm’s Supply Curve
Quantity (sweaters per day)7 9 10
17
25
31
Mar
gina
l rev
enue
& m
argi
nal c
ost
(do
llar
s pe
r da
y) MC = S
MR0
AVC
s
Shutdown point
0
TM 12-37Copyright © 1998 Addison Wesley Longman, Inc.
A Firm’s Supply Curve
Quantity (sweaters per day)7 9 10
17
25
31
Mar
gina
l rev
enue
& m
argi
nal c
ost
(do
llar
s pe
r da
y) S
s
0
TM 12-38Copyright © 1998 Addison Wesley Longman, Inc.
Short-Run Industry Supply Curve
Short-run industry supply curve
Shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.
It is constructed by summing the quantities supplied by the individual firms.
TM 12-39Copyright © 1998 Addison Wesley Longman, Inc.
Industry Supply Curve
Quantity supplied Quantity supplied
Price by Sidney by industry(dollars (sweaters (sweaters
per sweater) per day) per day)
a 17 0 or 7 0 to 7,000
b 2 8 8,000
c 25 9 9,000
d 31 10 10,000
TM 12-40Copyright © 1998 Addison Wesley Longman, Inc.
S1
Industry Supply Curve
Quantity (thousands of sweaters per day)6 7 8 9 10
20
30
40
Pri
ce (
dolla
rs p
er s
wea
ter)
0
TM 12-41Copyright © 1998 Addison Wesley Longman, Inc.
Output, Price, and Profitin Perfect Competition
Industry demand and industry supply determine the market price and industry output.
Changes in demand bring changes to short-run industry equilibrium.
TM 12-42Copyright © 1998 Addison Wesley Longman, Inc.
D3
D2
Short-Run Equilibrium
Quantity (thousands of sweaters per day)6 7 8 9 10
17
25
Pric
e (d
olla
rs p
er s
wea
ter)
S
20
D1
Increase in demand:price rises and firmsincrease production
0
Decrease in demand:price falls and firmsdecrease production
TM 12-43Copyright © 1998 Addison Wesley Longman, Inc.
Profits and Losses in the Short-Run
At short-run equilibrium firms may:
• Earn a profit
• Break even
• Incur an economic loss.
TM 12-44Copyright © 1998 Addison Wesley Longman, Inc.
Profits and Losses in the Short-Run
If price equals average total cost a firm breaks even.
If price exceeds average total cost, a firm makes an economic profit.
If price is less than average total cost, a firm incurs an economic loss.
TM 12-45Copyright © 1998 Addison Wesley Longman, Inc.
Quantity (millions of chips per year)
Pri
ce (
dolla
rs p
er c
hip)
15.00
20.00
25.00
8 10
30.00
AR = MR
MC ATCBreak-evenpoint
Normal profit
0
Three Possible Profit Outcomesin the Short-Run
TM 12-46Copyright © 1998 Addison Wesley Longman, Inc.
EconomicProfit
0Quantity (millions of chips per year)
Pri
ce (
dolla
rs p
er c
hip)
15.00
20.33
25.00
Three Possible Profit Outcomesin the Short-Run
9 10
30.00
AR = MR
MC ATC
Economic profit
TM 12-47Copyright © 1998 Addison Wesley Longman, Inc.
Economicloss
AR = MR
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
17.00
20.14
25.00
Three Possible Profit Outcomesin the Short-Run
30.00
MC ATC
Economic loss
7 100
TM 12-48Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Explain why firms enter and leave an industry
• Predict the effects of a change in demand and of a technological advance
• Explain why perfect competition is efficient
TM 12-49Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Adjustments
Forces in a competitive industry ensure only one of these situations is possible in the long-run.
Competitive industries adjust in two ways:
• Entry and exit
• Changes in plant size
TM 12-50Copyright © 1998 Addison Wesley Longman, Inc.
Entry and Exit
The prospect of persistent profit or loss causes firms to enter or exit an industry.
If firms are making economic profits, other firms enter the industry.
If firms are making economic losses, some of the existing firms exit the industry.
TM 12-51Copyright © 1998 Addison Wesley Longman, Inc.
Entry and Exit
This entry and exit of firms influence price, quantity, and economic profit.
Let’s investigate the effects of firms entering or exiting an industry.
TM 12-52Copyright © 1998 Addison Wesley Longman, Inc.
S0
Entry and Exit
Quantity (thousands of sweaters per day)
6 7 8 9 10
Pri
ce (
dolla
rs p
er s
wea
ter)
S2
23
17
20
D1
S1
Entry increasessupply
Exitdecreasessupply
0
TM 12-53Copyright © 1998 Addison Wesley Longman, Inc.
Entry and Exit
Important Points
As new firms enter an industry, the price falls and the economic profit of each existing firm decreases.
As firms leave an industry, the price rises and the economic loss of each remaining firm decreases.
TM 12-54Copyright © 1998 Addison Wesley Longman, Inc.
Changes in Plant Size
When a firm changes its plant size, it can lower its costs and increase its economic profit.
Let’s see how a firm can increase its profit by increasing its plant size.
TM 12-55Copyright © 1998 Addison Wesley Longman, Inc.
Quantity (sweaters per day)
Pri
ce (d
olla
rs p
er s
wea
ter)
14
25
40
Plant Size and Long-Run Equilibrium
20
6 8
SRAC0
MC0
MC1 SRAC1
MR0
MR1
LRAC
Long-runcompetitiveequilibrium
m
Short-run profitmaximizing point
TM 12-56Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Equilibrium
Long-run equilibrium occurs in a competitive industry when firms are earning normal profit and economic profit is zero.
Economic profits draw in firms and cause existing firms to expand.
Economic losses cause firms to leave and cause existing firms to scale back.
TM 12-57Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Equilibrium
So in long-run equilibrium in a competitive industry, firms neither enter nor exit the industry and firms neither expand their scale of operation nor downsize.
TM 12-58Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Explain why firms enter and leave an industry
• Predict the effects of a change in demand and of a technological advance
• Explain why perfect competition is efficient
TM 12-59Copyright © 1998 Addison Wesley Longman, Inc.
Changing Tastes and Advancing Technology
Demand has fallen tremendously for tobacco, trains, TV and radio repair, and sewing machines.
Demand has increased dramatically for microwave utensils, paper plates, and flash memories.
TM 12-60Copyright © 1998 Addison Wesley Longman, Inc.
Changing Tastes and Advancing Technology
What happens in a competitive industry when a permanent change in demand occurs?
TM 12-61Copyright © 1998 Addison Wesley Longman, Inc.
P0MR0
ATC
MC
MR1P1
D1
D0
S0
A Decrease in Demand
Quantity
Pric
e
0 Quantity
Pric
e an
d C
ost
P0
Industry Firm
P1
q0q1Q0Q1
S1
Q2
TM 12-62Copyright © 1998 Addison Wesley Longman, Inc.
External Economies and Diseconomies
External economies
Factors beyond the control of an individual firm that lower its costs as the industry increases.
External diseconomies
Factors outside the control of a firm that raise the firm’s costs as industry output increases.
TM 12-63Copyright © 1998 Addison Wesley Longman, Inc.
External Economies and Diseconomies
We will use this information to develop a
long-run industry supply curve.
TM 12-64Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Changes in Price and Quantity
Constant-cost industry Increasing-cost industry Decreasing-cost industry
Quantity
Pri
ce
P0
Q0
D1
Ps
S0
Quantity
Pri
ce
P0
Q0
D0
D1
Ps
S0
Quantity P
rice
P0
Q0
D0
D1
Ps
S0S1
Qs Qs QsQ1
LSA LSC
P2
Q2
S3
S2
P3
Q3
LSB
D0
TM 12-65Copyright © 1998 Addison Wesley Longman, Inc.
Changing Tastes and Advancing Technology
Technological change
New technology allows firms to produce at lower costs.
This causes their cost curves to shift downward.
Firms adopting the new technology make an economic profit.
This draws in new technology firms.
Old technology firms disappear, the price falls, and the quantity produced increases.
TM 12-66Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Explain why firms enter and leave an industry
• Predict the effects of a change in demand and of a technological advance
• Explain why perfect competition is efficient
TM 12-67Copyright © 1998 Addison Wesley Longman, Inc.
Competition and Efficiency
Resources are used efficiently when there is:
• Consumer efficiency
• Producer efficiency
• Exchange efficiency
TM 12-68Copyright © 1998 Addison Wesley Longman, Inc.
Competition and Efficiency
Consumer efficiency is achieved when it is not possible for consumers to become better off — to increase utility — by reallocating their budgets.
• On the household’s demand curve
• External benefits
Producer efficiency occurs when a firm is producing at any point on its marginal cost curve, or equivalently, on its supply curve.
• External costs
TM 12-69Copyright © 1998 Addison Wesley Longman, Inc.
Competition and Efficiency
Exchange efficiency occurs when all the gains from trade have been realized (i.e. consumer and producer surplus).
TM 12-70Copyright © 1998 Addison Wesley Longman, Inc.
Quantity
Pri
ce
P*
Efficiency of Competition
S
D
Q*
Consumersurplus
Producersurplus
B0
Efficient allocation
C0
Q0
TM 12-71Copyright © 1998 Addison Wesley Longman, Inc.
Efficiency of Perfect Competition
Perfect competition enables resources to be used efficiently if there are no external benefits and external costs.
• External costs and external benefits
• Goods providing external benefits would be underproduced, while goods providing external costs would be overproduced.
• Monopoly
• Monopoly restricts output below its competitive level to raise price and increase profit.