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9 Perfect Competition

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Learning Outcomes

After reading this chapter, you should be able to

• Describe the assumptions of perfect competition.

• Explain the relationship between a perfectly competitive firm and the total market and its short-run adjustments.

• Define the shutdown point in terms of price and average variable costs or total fixed costs and losses.

• Describe the long-run supply curve for a constant cost industry, an increasing cost industry, and a decreas- ing cost industry.

• Identify the long-run equilibrium for the firm and the industry under perfect competition.

192

Section 9.1 The Characteristics of Perfect Competition

Introduction Some firms, like convenience stores and grocery chains, are open 24 hours a day. Others close at 6:00 or 7:00 p.m. Some bars and restaurants open at 11:00 a.m. to cater to the lunch crowd, while others don’t open until 4:00 p.m. for the happy hour crowd. Some resorts are open year- round, while others close for business during the off-peak season.

How can you explain this distinctly different behavior across firms that are in the same indus- try? Any firm that makes production decisions will relate potential, or forecasted, revenues to costs in order to determine output levels. However, the forecasted revenues will depend on the market conditions faced by the firm. After studying the material in this chapter, you will be able to explain why firms in the same industry make different choices, whether they choose to close at 7:00 p.m., close for the winter, or close permanently.

This chapter and the next two look at four different models, referred to as market structures. The model discussed in this chapter is perfect competition. Perfect competition is a market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the market or industry. It is important to keep in mind that this is a theoretical model. Even if a perfectly competitive market does not exist, the model is useful because it provides a point of reference. Certain markets—for example, corn or soy—may be close to perfect competition. The perfectly competitive market is the most competitive market structure possible and will be the one to which we compare other market structures.

9.1 The Characteristics of Perfect Competition There are six basic assumptions for the model of perfect competition. In developing the the- ory, we assume that all firms in the market in which the product is sold possess these six characteristics:

1. There are numerous sellers (producers) in the market. A large number means there are so many sellers of the product that no single seller’s decisions can affect price. For example, no single wheat farmer can influence the price of wheat. A farmer could sell the entire crop or none of the crop. The farmer’s decision wouldn’t affect the price of wheat in any perceptible manner because the market for wheat is so large relative to any single producer.

2. There are numerous buyers (consumers) in the market. A large number means that no one buyer can affect the price in any perceptible way. That is, no single purchaser has any market power.

3. Perfectly competitive firms produce a homogeneous product. Homogeneous means that the product of one firm is no different from that of other firms in the industry; thus, they are perfect substitutes. Since this is the case, purchasers have no prefer- ence for one producer over another. If you are a miller and want to purchase wheat, you don’t care if it was produced by Farmer Jones or Farmer Smith—a bushel of No. 1 winter wheat is a bushel of No. 1 winter wheat.

4. There is free entry into and free exit out of the market or industry. This means that if one firm wishes to go into business or if another firm wishes to cease production,

193

Section 9.1 The Characteristics of Perfect Competition

either can do so without any kind of constraint. This assumption is crucial in dis- tinguishing perfect competition from monopoly, which we will examine in the next chapter.

5. There is perfect knowledge. This means that knowledge, such as information about sellers, prices, and costs, is freely available to all individuals and firms.

6. Workers and other resources can easily move in and out of the industry. These last two assumptions are even more unrealistic than the others because information is costly to acquire and resources are usually costly to move. The effect of these two assump- tions is that when economic profits exist, firms will find out about these profits and enter the industry. Even though these assumptions are unrealistic, the resulting model is valuable because it shows what adjustments would take place in an ideal setting.

A perfectly competitive market implies that no firm or individual has the power to exert con- trol over the market. This means that neither buyers nor sellers have any influence over price.

Economics in Action: What Criteria Are Necessary for Perfect Competition?

Looking at the airline industry, the Khan Academy lists the criteria for perfection competition. Follow the link to The Khan Academy (http://www.khanacademy.org) and search for the video “Perfect Competition” to find out how these criteria apply to any market.

Large Numbers of Buyers This chapter concentrates on developing a theory of firms in perfect competition, or com- petition on the sellers’ side of the market. Keep in mind, however, that we also assume large numbers of buyers—so many that no single firm possesses market power.

Concentrating on the firm should not obscure the importance of competition on the buyers’ side of the market. For markets to be competitive, there must be enough buyers that none can affect the market price by withholding purchases. Note also that perfect competition and free markets are not necessarily the same. A free market means a market that is free of govern- ment regulation—thus, a perfectly competitive market could also be a free market, but the reverse is typically not the case.

Check Point: Perfect Competition Assumptions

• Many sellers • Many buyers • Homogenous product • Free entry to/exit from the market • Perfect knowledge • Resources move freely

http://www.khanacademy.org

194

Section 9.2 Competitive Adjustment in the Short Run

9.2 Competitive Adjustment in the Short Run Since the perfectly competitive firm is small relative to the market and its product is the same as that of other firms, this firm views itself as having no influence on market price. If the per- fectly competitive firm wants to sell any of its output, it must sell at the market price. A firm in perfect competition is referred to as a price taker because it has no influence on price. It can sell any amount at the market-clearing price. The firm takes that price as its selling price. If it sets a higher price, none of its output will be sold, because buyers will be able to purchase an identical product at the lower market price elsewhere. On the other hand, it makes no sense to sell below the market price, because the firm can sell all it produces at that market price.

The market demand and supply curves and the firm’s resultant demand curve are shown in Figure 9.1. (The graphs in this chapter are based on models first developed by 19th-century British economist Alfred Marshall.) Market demand (D) and supply (S) curves are such that the market equilibrium price is P1 = $10. If the market is in equilibrium, the perfectly competi- tive firm can sell as much of its product as it wishes at price P1. From the firm’s viewpoint, the demand curve is perfectly elastic at price P1.

Figure 9.1: Elastic demand at market equilibrium

In perfect competition, a firm’s demand curve is perfectly elastic at the market equilibrium price.

0 Bushels/ time period

Bushels/ time period

Price

Price (a) Firm (b) Market

$10 $10

D = MR

The demand schedule a firm faces is also its average revenue schedule. If, for example, the price consumers pay in the market is $10, the average revenue a seller receives per unit sold is also $10. As price changes along a market demand curve, the average revenue that sellers receive will also change. Total revenue of a firm is the price times the quantity sold (TR = P × Q). Marginal revenue (MR) is the change in total revenue from selling one more unit. With perfect competition, price does not vary with output. Thus, MR is a constant. The firm’s perfectly elas- tic demand curve in Figure 9.1 is also a perfectly elastic average revenue curve.

195

Section 9.2 Competitive Adjustment in the Short Run

The Level of Output Recall that a profit-maximizing firm always produces that quantity for which marginal rev- enue is equal to marginal cost. Using marginal cost and marginal revenue, we now can deter- mine how a perfectly competitive firm will adjust its output to changed prices in the short run. Figure 9.2 shows the demand curves for (a) an individual soybean farmer (one of the numerous, identical firms) and (b) the market for soybeans. The marginal cost curve for the farmer is also shown. This farmer maximizes profit by producing quantity x1 = 2,200 bush- els when the price per unit is P1 = $10 because at that output level, MR1 = MC. Now assume the market demand increases to D2. The market price rises to P2 = $12. The firm’s marginal revenue curve shifts upward to MR2. The firm responds by increasing its output level to x2 = 2,500 bushels where MR2 = MC.

Figure 9.2: Profit maximization

An increase in market demand causes the equilibrium price to rise. The demand curve the firm faces adjusts by the amount of the increase in price, and the firm increases its output to equate MC and MR. The adjustment process is such that the firm’s marginal cost curve is its short-run curve.

0 Bushels/ time period

Bushels/ time period

Price, cost

Price (a) Firm (b) Market

$10

2,200

MC S

MR 1

MR 2

D 1

D 2

$12

$10

$12

2,500

Economics in Action: Plotting Profits and Perfect Competition

Free Econ Help uses graphs to explain perfect competition (where marginal cost equals marginal revenue) and how one can identify profit maximization. Follow the link to see at https://youtu.be/eh1cc6P-eeI.

https://youtu.be/eh1cc6P-eeI

196

Section 9.2 Competitive Adjustment in the Short Run

The Supply Curve Changes in market price cause the firm to increase or decrease production along its marginal cost curve until MR = MC. For example, if a new soybean product gains popularity, this would increase demand for soybeans, and the market price would increase. A market prices go up or down, the profit maximizing price–output combinations change, generating a supply curve. As the market price rose, the farmer depicted in Figure 9.2 increased the output of soybeans. The quantity which will be produced at each price is identified by the marginal cost curve.

We can now look at the relationship between the firm’s supply (marginal cost) curve and the market supply curve. The firm’s supply curve represents its output response to increased market prices. Just as an industry is made up of all the firms that produce and sell homoge- nous goods, the short-run supply curve of an industry is the sum of supply curves for all firms in the industry. If we were to add the output (horizontally) across the short-run supply curves for all firms, we would construct the short-run market (or industry) supply curve. The mar- ket supply curve is simply the aggregate of all the firms’ supply curves. The short-run market supply curve, then, is the aggregate of the portions of all firms’ marginal cost curves that lie above their average variable cost curves. In the long run, more firms can enter an industry as a response to economic profits. The market supply curve will shift to the right because it is made up of more individual supply curves. On the other hand, as firms leave an industry due to losses, the market supply curve will shift to the left, representing a decrease in supply. This decrease is due to the fact that there are fewer individual supply curves to be summed.

Profits and Losses We have just seen how an individual firm in a perfectly competitive market adjusts in the short run to changes in market demand. Next, we need to determine the profits (or losses) of the firm. To find out, we need to add the average total cost curve to the graph. Also, in order to decide if the firm should continue to produce if losses are encountered, we need to add the average variable cost curve.

In Figure 9.3 the firm is maximizing profit by producing output x1 at price P1 = $10 where P = MR = MC. The average cost of producing x1 = 2,200 is AC = $10 in Figure 9.3. The total cost of producing x1 is AC × x1, or $10 × 2,200 = 22,000 (represented by the area of the shaded rect- angle in Figure 9.3). Total revenue in Figure 9.3 is also P1 × x1 = 22,000, so TR = TC. This firm is therefore making zero economic profit, although it is meeting its opportunity costs. Remem- ber that total cost includes normal profit, which is the return on capital and enterprise neces- sary to keep firms in an industry.

197

Section 9.2 Competitive Adjustment in the Short Run

The point at which the firm is making only a normal rate of return, or zero economic profit, is the breakeven point. If there is zero economic profit, then P = ATC and so ATC = P = MR = MC. The breakeven point occurs at the intersection of the average total cost (ATC) curve and the marginal cost (MC) curve. If price rises above the breakeven point, the firm will make an economic profit; if the price falls below breakeven, the result will be a negative economic profit.

If the firm’s average total cost (ATC) curve is the one drawn in Figure 9.4, the average cost of producing x1 is point A on the graph. Total revenue (TR) is still P1 × x1 = 22,000. Total cost is now AC times x1, or $8 × $2,200 = $17,600. Since TR > TC, there is an economic profit equal to $22,000 – $17,600 = $4,400. However, if the firm’s average cost curve is the one drawn in Figure 9.5, the average cost of producing x1 is AC = $12. Total revenue is P1 × x1 = 22,000, and total cost is AC × x1, or $12 × 2,200 = 26,400. In this case, TC > TR, so economic losses are being incurred. The economic loss is equal to $22,000 – $26,400 = –$4,400.

Should the soybean farmer of Figure 9.5 continue to produce and, if so, for how long? The farmer is suffering a loss, but keep in mind that this diagram shows the short run, which means that some input is fixed. This fixed input means that there are fixed costs that cannot be eliminated. Fixed costs must be paid in the short run even if production ceases. Because variable costs are the only ones under the firm’s control in the short run, we need to include the average variable cost (AVC) curve to determine the conditions under which the firm should cease production.

Figure 9.3: Firm earning zero economic profit

The average cost (ATC) curve is used to determine if a firm is making an economic profit. If average revenue (price) is equal to average cost, the firm is making zero economic profit.

Price, cost

Bushels/time period

$10

2,200

D = MR

MC ATC

198

Section 9.2 Competitive Adjustment in the Short Run

Figure 9.4: Firm earning an economic profit

If the firm’s average revenue is greater than its average cost at the level of output being produced, the firm is making an economic profit.

Price, cost

Bushels/time period

$10

2,200

D = MR

ATC

Profit

Figure 9.5: Firm suffering a loss

If the firm’s average cost is greater than its average revenue at the level of output being produced, the firm is incurring a loss.

Price, cost

Bushels/time period

$10

$12

$2,200

D = MR

MC ATC

Loss

199

Section 9.3 The Shutdown Decision

9.3 The Shutdown Decision Figure 9.6 shows several equilibrium points depending on different levels of market demand (as shown by higher or lower MR for the firm). At a price of P1 = $10, which represents a marginal revenue of MR1, the firm maximizes profits by producing x1 = 2,200 where MR = MC (point A). At P1, the firm is making an economic profit, because total revenue ($22,000) is greater than total cost ($17,600). At price P2 = $7 = MR2, the firm would produce x2 = 2,000 and make zero economic profit, because total revenue ($14,000) is equal to total cost ($14,000). Notice that this point B lies at the intersection of the average cost and marginal cost curves. This, then, is the breakeven point, and the firm makes zero economic profit.

Figure 9.6: The shutdown point

If a firm’s average revenue is greater than its average variable cost, the firm will be able to cover total variable costs and make a payment toward total fixed costs. If price falls below average variable costs, the firm will lose less money if it shuts down than if it continues to produce. The shutdown point in this case is point C at a price of P3 = $5.

Price, cost

Bushels/time period

MR 1

ATC AVC

MR 2

$7 $8

$8.5

1,800 2,000 2,200

MR 3

$10

Examine carefully what happens when price falls to P3 = $5 and marginal revenue falls to MR3. The loss-minimizing output is still where MR = MC, which is now x3 = 1,800. At this output level, the firm incurs economic losses because total revenue is $5 × 1,800 = $9,000 and total cost is AC3 × x3, or $8.50 × 1,800 = $15,300. Economic losses are thus $9,000 – $15,300 = –$6,300. The firm needs to answer this question: Should it produce and incur this loss, or should it cease production? Remember, if production is halted, fixed costs must still be paid. In Figure 9.6, if the market price is P3, the firm’s marginal revenue is equal to average variable cost (AVC). In other words, the firm is covering (exactly) its total variable costs and losing an amount equal to its total fixed costs. It must pay the fixed costs even if it shuts down, so at price P3 = $5, the firm is indifferent about shutting down or continuing to produce. If the price falls below $5, the firm should shut down in order to minimize losses. By shutting down, it will lose only total

200

Section 9.3 The Shutdown Decision

fixed costs, instead of losing total fixed costs plus some portion of variable costs (as it will if it continues to produce). The minimum or low point on the AVC curve where it intersects the MC curve (point C in Figure 9.6) is called the shutdown point because if price falls below that point, the firm minimizes its losses by producing zero output.

At any price below P3, the firm is losing more than its total fixed costs. The firm would be bet- ter off shutting down and only incurring its fixed costs.

Because the firm shuts down, we need to modify the earlier statement that the firm’s mar- ginal cost curve represents its short-run supply curve. A firm’s short-run supply curve is rep- resented by its marginal cost curve only above the shutdown point (point C in Figure 9.6). Below the shutdown point, the firm will produce no output, so only the part of the marginal cost curve above the minimum point on the average variable cost curve is the firm’s supply curve.

The model has just told us that in the short run, the firm will shut down when price falls below average variable cost. It says nothing about the real-world timing of such a shutdown. The decision to shut down is more difficult in reality than in theory. It depends on many fac- tors, including time and anticipated changes. A few examples may illustrate such problems.

First, imagine yourself the owner of a sporting goods store in a ski area or a beach resort. Shutdown may be a seasonal decision. If revenues fall below average variable costs (clerks’ wages, electricity, and so on) in the off-season, you may close up, bearing only your fixed costs (such as rent on the store) until crowds return and your revenues increase. In this case, shutdown does not mean you are moving your investments in plant and equipment into other businesses. It simply means that you lose money in certain seasons and you lose less money if you shut down. You fully intend to reopen for business when the snow flies or the tempera- ture sends people to the beaches. Past experience helps you determine when to shut down and when to reopen.

Second, imagine yourself the owner-manager of a coal mine. Burning coal has fallen out of favor, and now the price of coal has fallen below your average variable costs of production. In the short run, you shut down (if laws and union contracts allow you to do so—a union con- tract might change labor from a variable to a fixed resource). The short run is too short a time period for you to vary the number of coal mines you own (which is one way of saying that you can’t move your fixed resources in this time period). If, however, you are convinced that this low price is permanent, you will begin to liquidate. You will sell equipment and attempt to sell your land and other fixed assets. As you do this, you are moving to the long run.

Check Point: What Short-Run Cost Curves Tell Us

• The minimum point on the average cost curve is the least cost combination. • The minimum point on the average variable cost curve is the shutdown point. • The part of the marginal cost curve above the average variable cost curve is the

perfectly competitive firm’s supply curve. • Profit or loss is measured as total revenue (measured as marginal revenue times

output) minus total cost (measured as average cost times output).

201

Section 9.3 The Shutdown Decision

Global Outlook: The Organization of Markets in Developing Countries

In many countries markets are not as well developed as they are in the United States. In these countries many nonmarket institutions have strong holds that affect production, distribution, and consumption. The laws of supply and demand still hold, but customs, systems of land tenure, village and family organization, religious practices, and corruption all have an impact on the functioning of markets.

Cultural differences affect the emergence of entrepreneurs and the profit motive. In poor countries entrepreneurs may lack the help of markets to bring together materials, labor, and capital. If individuals are discouraged from being risk takers, their reaction may be to say no to new business opportunities. These kinds of cultural obstacles make economic development more difficult in many developing countries, because development requires a strong entrepreneurial class. Also, if the ruling structure of a society does not encourage entrepreneurial development but supports the stability of a traditional society, this influence slows economic growth.

Another difference between the markets of developing and industrialized countries is that retail markets are often less organized and the products are less standardized. As a consequence, neither buyers nor sellers are price takers. Instead, much time and effort is expended in negotiating prices, which is time that does not go into producing goods and services.

Almost all developing countries are really two societies in the same country—one modern, urban, and market oriented, and the other made up of rural workers who are largely employed in agriculture, have little access to education, and whose economic activity largely does not pass through the market. This coexistence is called dualism.

Cities in developing countries contain many poor people but also have modern transportation and plumbing, manufacturing and service jobs, culture, a concentration of educated people, and a modern market economy. Birthrates are lower, and women are more likely to have access to education and market opportunities. Rural areas, in contrast, tend to maintain traditional lifestyles with centuries-old farming methods, early marriage with many children, and much home production with few market transactions. Most citizens in rural areas live in poverty or near poverty, generating little saving and investment.

(continued)

DAJ/Thinkstock Kongjongphotostock/iStock/Thinkstock

Markets in some countries are not as developed as markets in other countries. Almost all developing countries are really two societies in the same country—one modern and market oriented and the other rural and less economically active.

202

Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs

9.4 The Long Run: Constant, Increasing, or Decreasing Costs

The process of determining price and output, when firms have time to alter their fixed inputs and when new firms can enter the industry, is illustrated in Figure 9.7. Imagine D1 and S1 are the equilibrium demand and supply curves for the soybean industry. The industry is in long- run equilibrium when no economic forces are working to cause it to expand or contract (or to cause the price to change). In part (a) of the figure, the firm is making zero economic profit at price P1 = $7 and output x1 = 2,000. Let’s assume this firm is representative of 1,000 identi- cal firms. Thus, the market supply curve (S1) in part (b) is the summation of 1,000 MC curves (above the AVC curves). Since these firms are making zero economic profits at P1, the industry is in equilibrium with an industry output of Q1 = 2 million bushels (with each firm produc- ing x1 = 2,000 bushels). Now suppose there is an increase in market demand to D2, brought about by an increase in consumers’ real income, and assume that soybeans are a normal good. When market demand shifts to D2, market price rises to P2 = $10. The demand curve for the firm rises to D2 and is perfectly elastic at price P2.

The firm’s initial (short-run) response is to increase its output to x2 = 2,200 because MR2 = MC at output level x2. Thus, the increase in market demand from Q1 to Q2 is met by an increase in output by each of the 1,000 firms, from x1 to x2. Note, however, that each firm will then make an economic profit equal to the shaded area in Figure 9.7(a). Economic profit, you recall, means that productive resources are earning more than their opportunity cost. This profit means that the industry is out of equilibrium. Other firms are going to attempt to get some of this profit. The existence of profit is the signal for new firms to enter this industry.

Global Outlook: The Organization of Markets in Developing Countries (continued)

China is one example of a nation with a dualistic economic structure. Following the opening of trade barriers and booming economic growth reaching a high of 14% per year in 1992 and still greater than 6% in 2017, China is poised to offer its citizens a far greater standard of living (Trading Economics, n.d.). However, that greater standard of living has not reached many regions of China, where access to running water and basic health care is still very much a problem.

Dualism can be a major handicap to development. The urban population in a dual economy is often too small to provide a market for manufacturing and services or to generate enough saving and investment in human and physical capital. It is easy for people in developed countries to take markets and entrepreneurs for granted and overlook the role they play in creating and sustaining a high standard of living.

203

Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs

Since free entry and perfect knowledge are assumed to be characteristics of perfect compe- tition, entrepreneurs will be aware of this profit and will enter the industry. As firms enter the industry, the market supply curve will shift. In fact, firms will keep entering the industry until equilibrium (zero economic profit) is restored. This is illustrated in Figure 9.7. Equilib- rium will be restored when the price has been reduced to P1, the original equilibrium price. The new equilibrium price and quantity is P1 and Q3 = 2.5 million bushels, where each firm produces x1 = 2,000 bushels, but there are now 2,250 firms in the market. Connecting the market equilibrium points, points A and B in Figure 9.7(b), gives the industry’s long-run sup- ply curve, LR.

Just as profits are the signal for firms to enter an industry, losses are the signal for firms to exit an industry. Entrepreneurs move their productive resources to other uses, seeking to earn profits elsewhere. As firms leave the industry, the short-run market supply curve will shift to the left because it is now derived by adding up the short-run supply curves of fewer firms. Firms will leave the industry until the remaining firms have zero economic profits or losses and equilibrium is restored.

Figure 9.7: Long-run adjustment to an increase in market demand

An increase in market demand will cause the price to rise. The demand curve the representative firm faces will shift upward. Economic profit will result, and new firms will enter the industry in response to this profit. As new firms enter, the market supply curve shifts to the right, causing price to fall to the point at which the representative firm is again earning zero economic profit.

0 Bushels/ time period

Bushels/ time period

Price, cost

Price (a) Firm (b) Market

2,000 2,200 Q 1

Q 2

Q 3

ATC

A B LR

D 1 = MR

$10 D

2 = MR

D 1

D 2

S 1

S 2

$10

204

Section 9.5 What’s So Great About Perfect Competition?

9.5 What’s So Great About Perfect Competition? The nature of perfect competition is such that the firm and industry are driven to equilibrium at zero economic profit. This equilibrium is the appeal of perfect competition as a standard against which to judge other market structures. Economists view this equilibrium as an ideal, or a social optimum. In equilibrium, resources are optimally allocated among competing uses. Figure 9.8 shows a perfectly competitive firm in equilibrium. At equilibrium, price (P) is equal to average total cost (ATC) and also is equal to marginal cost (MC).

Figure 9.8: The equilibrium condition for a perfectly competitive firm

In short-run equilibrium with perfect competition, allocative efficiency is met. This means that the resources of the firm are being allocated as consumers wish.

Price, cost

Quantity/time period

x 1

D = MR = LR

ATC

First, consider P = MC. This means that allocative efficiency is being achieved and that the resources of the firm are being allocated exactly as consumers wish. It means that firms are expanding production exactly to the level desired by society. If P were greater than MC, it would mean that not enough resources were going into the production of the good in ques- tion. Consumers would be willing to pay a higher price (P) than it costs to produce another unit of the good (MC). If P were less than MC, too many resources would be devoted to the production of the good. Consumers would not be willing to pay as much as it costs to pro- duce another unit of the good. In other words, where P = MC, the socially optimal (or correct) amount of resources is being devoted to producing the good.

Second, consider P = AC. This means that firms are earning only normal profits. There is no incentive for firms to enter or leave the industry. It is important to note the role of profits in the perfectly competitive model. Economic profits serve as the signal for firms to move in or out of an industry. When profits exist, entrepreneurs rush in to attempt to capture them. The industry is forced to a new equilibrium. When losses are present, entrepreneurs leave to seek higher returns elsewhere. Equilibrium is attained because of the profit-seeking nature of firms. In equilibrium, there is efficiency. It is not because of some altruistic behavior on the

205

Section 9.5 What’s So Great About Perfect Competition?

part of entrepreneurs that firms are efficient. Entrepreneurs are assumed to be profit maxi- mizers motivated by individual self-interest, and their response to changing profits brings about efficiency. In the competitive model, self-interest and the quest for profits produce the efficiency that benefits consumers. The firm is striving not for efficiency but for profits. When economic profits have served their signaling function, they disappear.

Third, consider MC = AC. This means that average cost (AC) is at a minimum. The variable resources are being combined as efficiently as possible.

In long-run equilibrium, shown as LR in Figure 9.8, P = ATC = MC = LR. This means several things:

1. The firm has no further opportunities to improve or to enhance profitability. 2. Any larger or smaller physical operations or production levels would be nonoptimal

and would result in economic losses. 3. Only the least cost, most efficient firms will survive in a perfect competition.

The model of perfect competition is not meant to be a precise description of reality. Nor is it, in every case, the ideal state that society should be striving to reach. In certain industries, it may be too costly to bring about the necessary conditions for perfect competition. For exam- ple, in most markets, buyers are not perfectly informed about all prices from all sellers. In that case, society can accept less than the ideal. The model of perfect competition is a theoretical tool for an economist. The economist can compare the real-world situation to the hypotheti- cal world of perfect competition to determine what would be the case if perfect competition existed. In this sense perfect competition is a benchmark, or yardstick, by which economists can measure the performance of other market structures.

Policy Focus: Floods, Subsidies, and the Farm Problem

Agriculture has become a complex and competitive industry, and farmers face numerous problems. Many well-intended programs add to the problems confronting productive farmers. Some of the programs aimed at aiding farmers hit hard by drought in 2017 are a case in point.

If the prices for farm products are “too low,” farmers suffer economic losses, and the competitive solution is for some farms to exit the industry. That is what has been happening since 1900 in the United States. As farm production falls, prices will rise to the point that existing farmers receive normal profits and remain in business.

Let’s consider the impact of a well-intended emergency program in place in 2017 to help farmers recover from production and physical losses from natural disasters. Even though the droughts of 2017 did not cause destruction in Minnesota, it was a poor year for growing soy. Luckily, the government EM loans program was triggered by an event like a drought and allowed farmers to borrow up to 100% of the actual production or physical losses less any other disaster-related compensation. The farmers could get a low-interest loan to get them through this difficult time. One of the conditions for the loan was that the farmer be unable to get adequate credit elsewhere (U.S. Department of Agriculture, n.d.).

(continued)

206

Conclusion

Conclusion The question we began with is now easy to answer. Firms shut down in the short run when average revenue does not cover average variable costs. For many firms, the timing of the revenue flow determines hours of operation. One restaurant may open at 11:00 a.m. while one across the street opens at 5:00 p.m. A resort with very slow off-peak business may incur losses if it remained open during the off-season. For the firm that is closed, the fixed cost is less than would be incurred if the firm were open for business.

Key Ideas

1. Perfect competition is characterized by large numbers of buyers and sellers, homo- geneous products, ease of entry into and exit out of the industry, perfect knowledge, and mobility of resources. Profits are the force that drives the perfectly competitive model to efficiency. The firm is seeking not efficiency, but profits. This search for profits produces the efficiency that characterizes the model of perfect competition. Large numbers of buyers in a perfectly competitive market ensure that no single buyer can influence price.

2. A firm in a perfectly competitive market faces a perfectly elastic demand curve at the price determined by equilibrium in the market. The firm’s short-run supply curve is the same as its short-run marginal cost curve.

Policy Focus: Floods, Subsidies, and the Farm Problem (continued)

Consider now the case of Manuel, a successful, energetic soy farmer. He has an efficient, well- run operation, has been making profit for many years, and had carefully managed his water resources and worked hard to get his soy planted at the right time to avoid the worst of the drought.

He is in pretty good shape and stands to make at least a normal profit this year. The best thing for his long-term economic interest would be for some of the marginal farmers in his market area to go out of business, decreasing supply. Manuel has no trouble going to the bank and getting a loan to finance his soy farm. He will get a farm loan and pay market interest rates, which may be 1%–2% higher. Yet he is going to have to compete with the marginal farmer down the road who can’t get a farm loan, but that marginal farmer will be able to get the low-interest government loan. Now Manuel has to compete with a neighbor that has a lower cost of financial capital. A policy designed to help an unfortunate individual has disadvantaged an individual who worked hard and was successful.

One of the most difficult challenges facing governmental policy makers is to understand that competition requires relatively free entry and exit. If the price of farm products is insufficient to enable normal profit, the only solution is for some farmers and some farm production to exit the industry.

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Conclusion

3. Since the firm will shut down when price falls below average variable cost, the actual short-run supply curve is the marginal cost (MC) curve above the minimum point on the average variable cost (AVC) curve. This point of intersection is known as the shutdown point.

4. Long-run adjustments to changes in market demand are dependent on the cost char- acteristics for the industry. Since entry is easy, additional firms will enter an industry as long as economic profits are present. Thus, economic profits, brought about by an increase in demand, will lead to new entry. An industry can be characterized by con- stant, increasing, or decreasing costs. The slope of the long-run market supply curve will depend on which of these cost situations prevails.

5. At perfectly competitive equilibrium, P = AC = MC = MR = LR. This condition describes the ideal allocative efficiency of perfect competition, to which other mar- ket structures are compared. From a society’s perspective, nothing can be done to improve the allocation of scarce resources.

Critical-Thinking Questions

1. What are the characteristics that describe a perfectly competitive market? Why is it important to have a large number of buyers and sellers?

2. What does it mean for a firm to be a price taker? How does this limit the ability of a firm in perfect competition to generate large profits?

3. Why might a firm continue to produce in the short run even if it was incurring a loss? Would this occur in the long run? Why or why not?

4. What does it mean to say that in perfectly competitive equilibrium, P = MC = MR = LRAC?

5. Explain how the long-run market supply curve will be determined by short-run sup- ply adjustments in an increasing cost industry.

6. Assume that the market for soy is perfectly competitive. If the market price is $5.50 per unit, what would happen if an individual farmer tried to sell at a price of $6.00? What would happen if the farmer set the price at $5.25?

7. Assume a firm in a perfectly competitive market can produce at a quantity where marginal revenue is less than average variable cost but greater than average fixed cost. Should the firm shut down? Why or why not?

8. Assume a firm in a perfectly competitive market can produce at a quantity that mar- ginal revenue is less than average variable cost and average fixed cost. Should the firm shut down? If so, what would determine whether it shut down temporarily or permanently?

9. Consider some markets that possess two or more characteristics of a perfectly com- petitive market. What types of products are they? How closely do they resemble the theoretical extreme of a perfectly competitive market?

10. One characteristic of a perfectly competitive market is free entry and exit. Why is this important? What would happen if there was not free entry into the market? What if there was not free exit from the market?

11. “If the price of wheat doesn’t rise, farmers will lose money and the long-run price will be even higher.” Analyze this statement.

12. What would happen to the price, output level, and profit for a firm in a perfectly competitive industry if the price of capital decreased? Distinguish between short-run and long-run impacts.

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Conclusion

13. Why do some ski resorts in Lake Tahoe, California, stay open all year, whereas others are only open during certain months of the year?

14. If there were a series of mergers among firms in a perfectly competitive market, would there be an impact on the market price? Why or why not?

15. Farmers in the Midwest occasionally share expensive machinery during harvest sea- sons. Why would competing firms choose to do this? What other motivation might they have?

Key Terms breakeven point The point at which the firm is making only a normal rate of return.

market power The ability of buyers or sell- ers to affect price.

perfect competition The market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the industry.

price taker A seller (or buyer) in perfect competition that has no influence on price and can sell (or buy) any amount at the market-clearing price.

shutdown point The minimum point on the average variable cost (AVC) curve, or the level of output at which a firm minimizes its losses by ceasing operation.