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Lecture Outlines

Perfect Competition

Reading: Chapter 8 of Tucker

Overview:

Perfect Competition
Short-Run Profit Maximization
Short-Run Loss Minimization
Short-Run Supply Curves
Long-Run Supply Curves
Three Types of Long-Run Supply Curves

Perfect Competition

Market Structure: A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry into and exit from the market.

Four market structures will be examined. The first is Perfect Competition.

Perfect Competition: A market structure characterized by:

A large number of producers and consumers, each too small individually to affect market price by way of the quantity they produce or consume,
A homogenous good or service produced at identical cost,
Very easy entry into or exit from the market.

This structure is a theoretical or ideal model, as no real-world market fits these three characteristics exactly.

What is meant by the three characteristics?

A large number of small firms: This condition is met when each firm is so small relative to the total market that no single firm can influence the market price.

Homogenous product: This means that buyers are indifferent as to which seller's product they buy.

Very easy entry and exit: This characteristic means that resources are completely mobile and can freely enter or exit a market.

Price taker: A seller that has no control over the price of the product it sells.

A firm operating in a perfectly competitive market is a "price taker."
The individual price taker firm's demand curve is perfectly elastic -- a horizontal line at the market equilibrium price. This means the firm cannot sell its product at even one penny higher than the equilibrium price, and will not sell its product at any lower than the equilibrium price.
Why?

Short-Run Profit Maximization for a Perfectly Competitive Firm

In a perfectly competitive market, a seller controls only one thing -- quantity of output it produces.

There are 2 profit maximization methods that lead to the same profit-maximizing output level -- the Total Revenue-Total Cost Method and the Marginal Revenue Equals Marginal Cost Method.

Total Revenue-Total Cost Method

Total Revenue (product price * quantity) - Total Cost = Total Profit or Loss

Graphically, profit is maximized when the vertical distance between the total revenue and total cost curves is the greatest. DRAW PICTURE.

Marginal Revenue Equals Marginal Cost Method

This approach uses marginal analysis by comparing marginal revenue (MR) and marginal cost (MC).

Marginal Cost (MC): The change in total cost as the output level changes one unit.

Marginal Revenue (MR): The change in total revenue from the sale of one additional level of output.

MR = (change in total revenue)/(change in output)

Since each firm is a price taker, the sale of each additional unit adds to total revenue an amount equal to the price. Therefore, marginal revenue equals the price that the firm views as a horizontal demand curve.

Graphically, MR is a horizontal line equal to market price, and MC follows a J-shaped pattern.
To determine the profit-maximizing level of output, firms use the MR=MC Rule: The firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost.

Short-Run Loss Minimization for a Perfectly Competitive Firm

A perfectly competitive firm must take the price determined by the forces of market supply and demand. Sometimes market conditions can lead to a drop in price, perhaps due to a decrease in demand and/or an increase in supply. Firms must make the best of the situation, which can mean short-run losses. But when should the firm produce and when should the firm shut down in the short run?

Example A: A Perfectly Competitive Firm Facing a Short-Run Loss But Still Produces

What do firms do if price falls to a point where there is no level of output at which the firm can make a profit?

The MR = MC rule still applies.

Suppose that market price is not high enough to pay the average total cost, but it is enough to pay the average variable cost with some left over to contribute toward paying a portion of the average fixed cost.

Example B: A Perfectly Competitive Firm Shuts Down

What do firms do if price falls below the average variable cost (AVC)?

If the price is below the minimum point on the AVC curve, each unit sold will generate marginal revenue that will not cover the average variable cost per unit, and, therefore, operating would increase losses. The firm should shut down, since then its losses are limited to TFC.

Short-run Supply Curves Under Perfect Competition

A. Perfectly Competitive Firm's Short-Run Supply Curve: The firm's marginal cost curve above the minimum point on its average variable cost curve.

The segment of the MC curve above its AVC curve.

B. Perfectly Competitive Industry's Short-Run Supply Curve: The supply curve derived from the horizontal summation of all firms' marginal cost curves in the industry above the minimum point of each firm's average variable cost curve.

Horizontal summation of quantities supplied by each firm at each price.

C. Short-Run Equilibrium for a Perfectly Competitive Firm: The intersection of the industry supply and demand curves. At the level of the firm, P = MC, and profits can be +, 0, or -.

Long-Run Supply Curves Under Perfect Competition

Recall the difference between the meaning of short-run and long-run.

The key to long-run equilibrium lies in the ability of firms to leave an industry that earns below normal profit or enter an industry that earns above normal profits.

New firms entering the industry shift the short-run supply curve to the right, causing price to fall.
Existing firms leaving the industry shift the short-run supply curve to the left, causing prices to rise.
Adjustments occur until economic losses are eliminated and economic profits equal zero in the long-run.

The conditions for long-run perfectly competitive equilibrium can be expressed as an equality:

P = MR = SRMC = SRATC = LRAC

P = Price
MR = Marginal Revenue
SRMC = Short-Run Marginal Cost
SRATC = Short-Run Average Total Cost
LRAC = Long-Run Average Cost

Perfectly Competitive Industry's Long-Run Supply Curve: The curve that shows the quantities supplied by the industry at different equilibrium prices after firms complete their entry and exit.

Three Types of Long-Run Supply Curves

Constant-Cost Industry: An industry in which the expansion of industry output by the entry of new firms has no effect on the firm's cost curves.

Input prices remain constant as new firms enter or exit the industry.
Causation chain:
Increases in demand sets a higher equilibrium price.
Entry of new firms increases supply.
Initial equilibrium price is restored.
The long-run supply curve is perfectly elastic (horizontal).

Decreasing-Cost Industry: An industry in which the expansion of industry output by the entry of new firms decreases the firm's cost curves.

Input prices fall as new firms enter the industry and output expands.
Economies of scale can explain this effect.
The long-run supply curve in this case is downward-sloping.

Increasing-Cost Industry: An industry in which the expansion of industry output by the entry of new firms increases the firm's cost curves.

Input prices rise as new firms enter the industry and output expands.
This type of industry uses more labor and machines, driving the demand and price for these inputs up.
The long-run supply curve in this case is upward-sloping.