Introduction to economics: perfect competition

Cost and Revenue Data for a Competitive Firm each quantity is the same as the market price demand curve facing firm are the same  A horizontal line at the market price... The Firm’s Sh

Chapter 7 Perfect Competition

Perfect Competition

 To determine structure of any particular market, we begin by asking

 How many buyers and sellers are there in the market?

 Is each seller offering a standardized product, more or less

indistinguishable from that offered by other sellers

• Or are there significant differences between the products of different firms?

 Are there any barriers to entry or exit, or can outsiders easily enter

and leave this market?

 Answers to these questions help us to classify a market into one of four basic types

 Perfect competition

 Monopoly

 Monopolistic

 Oligopoly

The Three Requirements of Perfect

Competition

 Large numbers of buyers and sellers,

and

the total quantity in the market

market

A Large Number of Buyers and Sellers

 In perfect competition, there must

be many buyers and sellers

 How many?

individual decision maker can significantly affect price of the product by changing quantity it buys or sells

A Standardized Product Offered by

Sellers

 Buyers do not perceive significant

differences between products of one

seller and another

one farmer’s wheat over another

Easy Entry into and Exit from the

Market

 Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and

establish contacts with customers

 But perfectly competitive market has no significant barriers to

discourage new entrants

• Any firm wishing to enter can do business on the same terms as firms that are already there

 In many markets there are significant barriers to entry

 Legal barriers

 Existing sellers have an important advantage that new entrants can

not duplicate

• Brand loyalty enjoyed by existing producers would require a new entrant

to wrest customers away from existing firms

 Significant economies of scale may give existing firms a cost

advantage over new entrants

Easy Entry into and Exit from the

Market

easy exit

sell off its plant and equipment and leave the

industry for good, without obstacles

completely change the environment in which trading takes place

Is Perfect Competition Realistic?

 Assumptions market must satisfy to be perfectly competitive are rather restrictive

 In vast majority of markets, one or more of assumptions of

perfect competition will, in a strict sense, be violated

 Yet when economists look at real-world markets, they use perfect

competition more often than any other market structure

 Why is this?

 Model of perfect competition is powerful

 Many markets—while not strictly perfectly competitive—come

reasonably close

 We can even—with some caution—use model to analyze

markets that violate all three assumptions

 Perfect competition can approximate conditions and yield

accurate-enough predictions in a wide variety of markets

Figure 1: The Competitive Industry and

the Firm

$400

Firm

1 The intersection of the market supply

and the market demand curve… 3 The typical firm can sell all it wants at the market price…

Ounces of Gold per Day

Price per Ounce

2 determine the equilibrium 4 so it faces a horizontal

Goals and Constraints of the

Competitive Firm

 Perfectly competitive firm faces a cost

constraint like any other firm

 Cost of producing any given level of

output depends on

The Demand Curve Facing a Perfectly

Competitive Firm

facing Small Time Gold Mines

• It’s horizontal, or infinitely price elastic

cannot make a noticeable difference in market

quantity supplied

• So cannot affect market price

The Demand Curve Facing a Perfectly

Competitive Firm

price of its output

• In perfect competition, firm is a price taker

 Treats the price of its output as given and beyond its control

price as given

and sell

Cost and Revenue Data for a

Competitive Firm

each quantity is the same as the market

price

demand curve facing firm are the same

 A horizontal line at the market price

Figure 2(a): Profit Maximization in

Figure 2(b): Profit Maximization in

The Total Revenue and Total Cost

Approach

 Most direct way of viewing firm’s search for the profit-maximizing output level

 At each output level, subtract total cost

from total revenue to get total profit at

that output level

The Marginal Revenue and Marginal

Cost Approach

long as marginal revenue > marginal cost

found where MC curve crosses MR curve

from below

a competitive firm requires no new concepts

or techniques

Measuring Total Profit

 Start with firm’s profit per unit

 Revenue it gets on each unit minus cost per unit

• Revenue per unit is the price (P) of the firm’s output, and cost per unit is our familiar ATC, so we can write

 Profit per unit = P – ATC

 Firm earns a profit whenever P > ATC

 Its total profit at the best output level equals area of a

rectangle with height equal to distance between P and

ATC, and width equal to level of output

 A firm suffers a loss whenever P < ATC at the best

level of output

 Its total loss equals area of a rectangle

• Height equals distance between P and ATC

• Width equals level of output

Figure 3(a): Measuring Profit or Loss

$400 300

Profit per Ounce ($100)

d = MR

MC ATC

Economic Profit

Ounces of Gold per Day Dollars

1 2 3 4 5 6 7 8

Figure 3(a): Measuring Profit or Loss

MC

ATC

d = MR

$300 200

Loss per Ounce ($100)

Economic Loss

Ounces of Gold per Day Dollars

1 2 3 4 5 6 7 8

The Firm’s Short-Run Supply Curve

 Takes market price as given and then decides how much

output it will produce at that price

traveling from the price, across to the firm’s MC

curve, and then down to the horizontal axis, or

 As price of output changes, firm will slide along its MC

curve in deciding how much to produce

 If the firm is suffering a loss large enough to justify

shutting down

• It will not produce along its MC curve

• It will produce zero units instead

Figure 4: Short-Run Supply Under

0.50

2,0004,000 7,000

1.00 2.00

$3.50 2.50

Bushel

Bushels per Year

The Shutdown Price

 Price at which a firm is indifferent between producing and

shutting down

 Can summarize all of this information in a single curve—

firm’s supply curve

 Tells us how much output the firm will produce at any price

 Supply curve has two parts

 For all prices above minimum point on its AVC curve, supply curve

coincides with MC curve

 For all prices below minimum point on AVC curve, firm will shut

down

• So its supply curve is a vertical line segment at zero units of output

 For all prices below $1—the shutdown price—output is zero and the supply curve coincides with vertical axis

Competitive Markets in the Short- Run

 Short-run is a time period too short for

firm to vary all of its inputs

 Quantity of at least one input remains fixed

 Let’s extend concept of short-run from

firm to market as a whole

 In short-run, number of firms in industry is

fixed

The (Short-Run) Market Supply Curve

individual firm in a market

 Can easily determine the short-run market supply curve

• Shows amount of output that all sellers in market will offer at each price

 To obtain market supply curve sum quantities of output supplied by all firms in market at each price

two things are constant

 Fixed inputs of each firm

 Number of firms in market

Short-Run Equilibrium

 How does a perfectly competitive market

achieve equilibrium?

 In perfect competition, market sums buying and

selling preferences of individual consumers and

producers, and determines market price

• Each buyer and seller then takes market price as given

 Each is able to buy or sell desired quantity

 Competitive firms can earn an economic

profit or suffer an economic loss

Figure 6: Perfect Competition

Quantity Demanded at Different Prices

Quantity Supplied at Different Prices

Quantity Supplied

by Each Firm

Quantity Demanded by

Quantity Demanded

by All Consumers at Different Prices

Quantity Supplied by All Firms at Different

D Q

Market Equilibrium Added together Added together

Figure 7: Short-Run Equilibrium in

7,000 4,000

2.00

$3.50

2 the typical firm operates here, earning economic profit in the short run.

1 When the demand curve is D 1 and

market equilibrium is here

Profit per Bushel

Dollars Firm

Bushels per Year

Loss per Bushel

at p = $2

Profit and Loss and the Long Run

 In a competitive market, economic profit and loss are the

forces driving long-run change

 Expectation of continued economic profit (losses) causes outsiders

(insiders) to enter (exit) the market

 In real world entry and exit occur literally every day

 In some cases, we see entry occur through formation of an entirely

new firm

 Entry can also occur when an existing firm adds a new product to its line

 Exit can occur in different ways

 Firm may go out of business entirely, selling off its assets and

freeing itself once and for all from all costs

 Firm switches out of a particular product line, even as it continues to produce other things

From Short-Run Profit to Long-Run

Equilibrium

• Increasing number of firms in market

 As number of firms increases, market supply curve will shift rightward causing several things to happen

 Market price begins to fall

 As market price falls, demand curve facing each firm shifts downward

 Each firm—striving as always to maximize profit—will slide down its marginal cost curve, decreasing output

From Short-Run Profit to Long-Run

Equilibrium

firm—continues until…well, until when?

 When the reason for entry—positive profit—no longer

exits

 Requires market supply curve to shift rightward enough,

and the price to fall enough

• So that each existing firm is earning zero economic profit

continues to attract new entrants until economic

profit is reduced to zero

Figure 8(a/b): From Short-Run Profit

To Long-Run Equilibrium

S 1

d 1 ATC

MC

$4.50

With initial supply curve

S 1, market price is $4.50…

$4.50

So each firm earns an

economic profit.

Dollars

Firm

Bushels per Year

D

Figure 8(c/d): From Short-Run Profit

To Long-Run Equilibrium

S 1

d 1 ATC

Dollars

Bushels per Year

D 1,200,000

From Short-Run Loss to Long-Run

Equilibrium

 Same type of adjustments will occur, only in the opposite

direction

to cause exit until losses are reduced to zero

 Economic loss will eventually drive firms from the

industry

• Raising market price until typical firm breaks even again

Distinguishing Short-Run from

Long-Run Outcomes

 In short-run equilibrium, competitive firms can earn profits or suffer losses

 In long-run equilibrium, after entry or exit has occurred, economic

profit is always zero

 When economists look at a market, they automatically think

of short-run versus long-run

 Choose the period more appropriate for the question at hand

 Basic Principle #7: Short-Run versus Long-Run Outcomes

 Markets behave differently in the short-run and the long run

 In solving a problem, we must always know which of these time

horizons we are analyzing

The Notion of Zero Profit in Perfect

Competition

competitive firm

all firms to earn zero economic profit also

ensure

will select its plant size and output level so that it operates at minimum point of its LRATC curve

Perfect Competition and Plant Size

 Figure 9(a) illustrates a firm in a perfectly competitive market

 But panel (a) does not show a true long-run equilibrium

 How do we know this?

• In long-run typical firm will want to expand

• Why?

 Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit

 By expanding firm could potentially earn an economic profit

• Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset

 Entry and expansion must continue in this market until the

price falls to P*

 Because only then will each firm—doing the best that it can do—earn zero economic profit

Figure 9: Perfect Competition and

3 As all firms increase plant size and

output, market price falls to its lowest possible level

1 With its current plant and ATC

curve, this firm earns zero

economic profit.

2 The firm could earn positive profit with a larger plant,

producing here.

A Summary of the Competitive Firm in

the Long-Run

 At each competitive firm in long-run equilibrium

• P = MC = minimum ATC = minimum LRATC

 In figure 9(b), this equality is satisfied when the

typical firm produces at point E

 Where its demand, marginal cost, ATC, and LRATC

curves all intersect

best deal they could possibly get

A Change in Demand

 Rise in market price

 Rise in market quantity

 Economic profits

shifts rightward?

 Market equilibrium will move from point A to point C

 Curve indicating quantity of output that all sellers in a

market will produce at different prices

• After all long-run adjustments have taken place

Figure 10: An Increasing-Cost Industry

per Unit

Figure 10: An Increasing-Cost Industry

Increasing, Decreasing, and Constant

Cost Industries

of those inputs to rise

common) is called an increasing cost

industry

• Shifts up typical firm’s ATC curve

 Raises market price at which firms earn zero economic profit

 As a result, long-run supply curve slopes upward

Increasing, Decreasing, and Constant

Cost Industries

 Other possibilities

 Industry might use such a small percentage of total inputs that—

even as new firms enter—there is no noticeable effect on input

prices

• Called a constant cost industry

 Entry has no effect on input prices, so typical firm’s ATC curve stays put

 Market price at which firms earn zero economic profit does not change

 Long-run supply curve is horizontal

 Decreasing cost industry, in which entry by new firms actually

decreases input prices

• Entry causes input prices to fall

 Causes typical firm’s ATC curve to shift downward

 Lowers market price at which firms earn zero economic profit

 As a result, long-run supply curve slopes downward

Market Signals and the Economy

 In real world, demand curves for different goods and

services are constantly shifting

 As demand increases or decreases in a market, prices

change

 Economy is driven to produce whatever collection of goods

consumers prefer

 In a market economy, price changes act as market signals,

ensuring that pattern of production matches pattern of

consumer demands

 When demand increases, a rise in price signals firms to enter

market, increasing industry output

 When demand decreases, a fall in price signals firms to exit market, decreasing industry output

Market Signals and the Economy

 Price changes that cause firms to change their

production to more closely match consumer demand