Chapter Ten: The Firm and the Industry Under Perfect Competition

Perfect Competition DefinedPerfect Competition: Occurs in an industry when that industry is made up of many mall firms producing homogeneous products, when information is perfect, and when there is no impediment to the entry or exit firms.

Not many examples besides shares in the stock market, farming, and fishing industries. We study perfect competition because only under perfect competition does the market mechanism perform

best. Fredrich Engels states that “only perfect competition can ensure that the economy turns out just those varies

and relative quantities of goods that match consumer preferences.”

The Competitive Firm To discover what happens in a perfectly competitive market, we must first deal separately with the behavior of

individual firms and the behavior of the industry that is constituted by those firms Under perfect competition, the firm has no choice but to accept the price that has been determined in the

market. We say that it is a price taker. The presence of a vast number of competitors forces firms to meet and not exceed the prices charged by their

competitors.

The Firm’s Demand Curve Under Perfect Competition A perfectly competitive firm faces a horizontal demand curve. This means that it can sell as much as it wants at

the prevailing market price. It can double or triple its sales without reducing the price of its product. This is possible because the competitive firm is so insignificant relative to the market as a whole that it has

absolutely no influence over price. Price is determined by supply and demand. Price curve is then a horizontal line because regardless of bushels

sold, price must match competitors prices

Short Run Equilibrium for the Perfectly Competitive Firm The only feature that distinguishes the profit maximizing equilibrium for the competitive firm from that of any

other type of firm is its horizontal demand curve. MR = P under perfect competition because the firm is a price taker. Because it Is a price taker, the equilibrium of a profit-maximizing firm in a perfectly competitive market must

occur at an output level at which marginal cost equals price. This is because a horizontal demand curve makes price and MR equal and, therefore, both must equal marginal cost according to the profit maximizing principle. In symbols: MC = P

Short Run Profit: Graphic Representation To determine whether the firm is making a profit or incurring a loss, we must compare total revenue (TR = P x Q)

with total cost (TC = AC x Q) Profit is AR – AC or distance between the point on the average cost curve to the point on the marginal cost curve Total profit is represented by the shaded rectangle whose height is the profit per unit and whose width is the

number of units The MC = P condition gives us the output that maximizes the perfectly competitive firm’s profit. It does not,

however, tell us whether the firm is making a profit or incurring a loss. To determine this, we must compare price (AR) with AC.

The Case of Short Term Losses Loss when the AC and MC curve are mostly above the demand curve. Shaded rectangle would be above the

demand curve representing a loss in profits.

Shutdown and Break-Even Analysis Rules that govern the decision to shut down or continue operations are:

- Rule One: The firm will make a profit if total revenue (TR) exceeds total cost (TC). In that case, it should not plan to shut down, either in the short run or the long run.

- Rule Two: The firm should continue to operate in the short run if TR exceeds total short-run variable cost (TVC). It should nevertheless plan to close in the long run if TR is less than TC.

It is better to keep operating as long as: TC – TR < TC – TVC or TVC < TR The firm will produce nothing unless price lies above the minimum point on the AVC curve

The Competitive Firm’s Short Run Supply Curve The short run supply curve of the perfectly competitive firm is that portion of its marginal cost curve that lies

above the point where it intersects the average (short-run) variable cost curve, that is, above the minimum level of AVC. If price falls below this level, the firm’s quantity supplied drops to zero.

The Competitive Industry’s Short Run Supply Curve Short Run for the industry period of time too brief for new firms to enter the industry of for old firms to

leave, so the number of firms is fixed Long Run for the industry period of time long enough for any firm to enter or leave as it desires. Each firm in

the industry can adjust its output to its own long run costs. The supply curve of the competitive industry in the short run is derived by summing the short-run supply curves

of all the firms in the industry horizontally. The supply curve of the industry will shift to the right whenever a new firm enters the industry

Industry Equilibrium in the Short Run For the competitive industry the demand curve normally slopes downward because each firm by itself is so small

that is it alone were to double its outputs the effect would hardly be noticeable. But if every firm in the industry were to expand its output, that would make a substantial difference.

Industry and Firm Equilibrium in the Long Run Industry equilibrium in the long run differs from the short run because the number of firms In the industry is not

fixed in the long run and long run firms can vary in plant size and change other commitments that were unchangeable in the short run.

Profits or loses are temporary for competitive firms because new firms are free to enter the industry if profits are greater than the average available.

Entry of new firms shifts original supply curve to the right causes a price decrease When a perfectly competitive industry is in long run equilibrium, firms maximize profits so that P = MC, and

entry forces the price down until it is tangent to the long-run average cost curve (P = AC). As a result, in long run competitive equilibrium it is always true that for each firm P = MC = AC

Zero Economic Profit: The Opportunity Cost of CapitalEconomic Profit: Equals net earnings, in the accountant’s sense, minus the opportunity costs of capital and of any other inputs supplied by the firm’s owners.

Because economists consider this 15 percent opportunity cost to be the cost of the firm’s capital, they include it in the AC curve. If the firm cannot earn at least 15 percent on its capital, funds will not be made available to it, because investors can earn greater returns elsewhere. In order to break even—to earn zero economic profit—a firm must earn enough not only to cover the cost of labor, fuel, and raw materials but also the cost of its funds, including opportunity cost of any funds supplied by the owners of the firm.

Zero profit in the economic sense simply means that firms are earning the normal, economy-wide rate of profit in the accounting sense. This result is guaranteed in the long run, under perfect competition by freedom of entry and exit.

The Long Run Industry Supply Curve The long run industry supply curve relates to the short run supply curve because:

- New firms enter or some exiting ones exit, which shifts the short run industry supply curve toward its long run position,

- Each firm in the industry is freed from its fixed commitments, the cost curves pertinent to its decisions become its long run cost curves rather than its short run cost curves.

Long run supply curve of the competitive industry must be identical to the industry’s long run average cost curve because in the long run, economic profit must be zero.

The price the industry charges cannot exceed the long run average cost of supplying that quantity because any excess of price over LRAC would constitute a profit opportunity that would attract new firms.

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 the entry or exit of firms and by the adjustment of firms already in the industry.

Perfect Competition and Economic Efficiency In the long run competitive equilibrium, every firm produces at the minimum point on its average cost curve.

Thus, the outputs of competitive industries are produced at the lowest possible cost to society.