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PERFECT COMPETITION

Notes and teaching tips: 5, 7, 17, 25, 28, 44, 48, 60, and 80.

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The producers of most crops—wheat, rice, coffee—must accept the price that the market determine.

During 2009, crop prices soared and so did production.

Then prices sagged, but production kept increasing for many crops.

What forces change in prices and production in the world’s markets for farm products?

To study competitive markets, we are going to build a model of a market in which competition is as fierce and extreme as possible.

We call this situation “perfect competition.”

What Is Perfect Competition?

Perfect competition is a market in which

Many firms sell identical products to many buyers.

There are no restrictions to entry into the industry.

Established firms have no advantages over new ones.

Sellers and buyers are well informed about prices.

The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly.

The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model!

Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

How Perfect Competition Arises

Perfect competition arises when:

the firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the market.

each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy.

What Is Perfect Competition?

Price Takers

In perfect competition, each firm is a price taker.

A price taker is a firm that cannot influence the price of a good or service.

No single firm can influence the price—it must “take” the equilibrium market price.

Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

What Is Perfect Competition?

Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast.

Economic Profit and Revenue

The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.

Total cost is the opportunity cost of production, which includes normal profit.

A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P  Q.

A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

What Is Perfect Competition?

Figure 12.1 illustrates a firm’s revenue concepts.

Part (a) shows that market demand and market supply determine the market price that the firm must take.

What Is Perfect Competition?

Figure 12.1(b) shows the firm’s total revenue curve (TR)—the relationship between total revenue and quantity sold.

What Is Perfect Competition?

Figure 12.1(c) shows the marginal revenue curve (MR).

The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.

What Is Perfect Competition?

The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm.

The market demand is not perfectly elastic because a sweater is a substitute for some other good.

What Is Perfect Competition?

A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces.

So the firm must decide:

1. How to produce at minimum cost

2. What quantity to produce

3. Whether to enter or exit a market

We start by looking at the firm’s output decision.

What Is Perfect Competition?

Profit-Maximizing Output

A perfectly competitive firm chooses the output that maximizes its economic profit.

One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves.

Figure 12.2 on the next slide looks at these curves along with the firm’s total profit curve.

The Firm’s Output Decision

Do firms really choose the output that maximizes profit? It is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit—and make graphs—similar to those in Figure 12.2. But most firms, and certainly most small firms like Campus Sweaters knitting firm, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin.

Part (a) shows the total revenue, TR, curve.

Part (a) also shows the total cost curve, TC, which is like the one in Chapter 11.

Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).

The Firm’s Output Decision

At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

At intermediate output levels, the firm makes an economic profit.

The Firm’s Output Decision

At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns.

The firm maximizes its economic profit when it produces 9 sweaters a day.

The Firm’s Output Decision

Marginal Analysis and Supply Decision

The firm can use marginal analysis to determine the
profit-maximizing output.

Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC.

Figure 12.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.

The Firm’s Output Decision

If MR > MC, economic profit increases if output increases.

If MR < MC, economic profit decreases if output increases.

If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

The Firm’s Output Decision

Temporary Shutdown Decision

If the firm makes an economic loss, it must decide to exit the market or to stay in the market.

If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily.

The decision will be the one that minimizes the firm’s loss.

The Firm’s Output Decision

Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost.

The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

Loss Comparisons

The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).

Economic loss = TFC + TVC  TR

= TFC + (AVC  P) x Q

If the firm shuts down, Q is 0 and the firm still has to pay its TFC.

So the firm incurs an economic loss equal to TFC.

This economic loss is the largest that the firm must bear.

The Firm’s Output Decision

The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

The Shutdown Point

A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down.

This point is where AVC is at its minimum.

It is also the point at which the MC curve crosses the AVC curve.

At the shutdown point, the firm is indifferent between producing and shutting down temporarily.

The firm incurs a loss equal to TFC from either action.

The Firm’s Output Decision

Figure 12.4 shows the shutdown point.

Minimum AVC is $17 a sweater.

If the price is $17, the profit-maximizing output is 7 sweaters a day.

The firm incurs a loss equal to the red rectangle.

When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion.

The Firm’s Output Decision

If the price of a sweater is between $17 and $20.14:

the firm produces the quantity at which marginal cost equals price.

The firm covers all its variable cost and some
of its fixed cost.

It incurs a loss that is less than TFC.

The Firm’s Supply Curve

A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same.

Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve.

But at a price below the shutdown point, the firm produces nothing.

The Firm’s Output Decision

Figure 12.5 shows how the firm’s supply curve is constructed.

If price equals minimum AVC, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

The Firm’s Decision

If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC.

If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC.

The blue curve in part (b) traces the firm’s short-run supply curve.

The Firm’s Decisions

Market Supply in the Short Run

The short-run market supply curve shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number of firms remain the same.

Output, Price, and Profit
in the Short Run

Figure 12.6 shows the supply curve for a market that has 1,000 firms like Campus Sweaters.

The quantity supplied by the market at any given price is the sum of the quantities supplied by all the firms in the market at that price.

Output, Price, and Profit
in the Short Run

At a price equal to minimum AVC, the shutdown price,

some firms will produce the shutdown quantity and others will produce zero.

At this price, the market supply curve is horizontal.

Output, Price, and Profit
in the Short Run

Short-Run Equilibrium

Short-run market supply and market demand determine the market price and output.

Figure 12.7 shows a short-run equilibrium.

Output, Price, and Profit
in the Short Run

A Change in Demand

An increase in demand bring a rightward shift of the market demand curve: The price rises and the quantity increases.

A decrease in demand bring a leftward shift of the market demand curve: The price falls and the quantity decreases.

Output, Price, and Profit
in the Short Run

Profits and Losses in the Short Run

Maximum profit is not always a positive economic profit.

To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price.

Figure 12.8 on the next slide shows the three possible profit outcomes.

Output, Price, and Profit
in the Short Run

In part (a) price equals average total cost and the firm makes zero economic profit (breaks even).

Output, Price, and Profit
in the Short Run

Operating a business at zero economic profit. Students are often skeptical that a zero economic profit is an acceptable outcome for an entrepreneur. The key is to reinforce the meaning of normal profit.

A rational decision is one that is based on a weighing of the full opportunity cost of each alternative against its full benefits—for a firm weighing the total revenue against the opportunity cost for each alternative.

Opportunity cost includes the benefits from forgone opportunities as well as explicit costs. One of these forgone opportunities is that of the entrepreneur pursuing her/his next best activity.

The value of this forgone opportunity is normal profit.

So, when a firm makes zero economic profit, the entrepreneur earns normal profit and enjoys the same benefits as those available in the next best activity. There is no incentive to change to the next best activity.

In part (b), price exceeds average total cost and the firm makes a positive economic profit.

Output, Price, and Profit
in the Short Run

In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative.

Output, Price, and Profit
in the Short Run

Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is appreciating that:

The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs.

The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision.

So for the firm to produce its revenues need only exceed avoidable costs, not total costs.

The profit-maximization goal doesn’t require the firm to make a positive economic profit in the short run.

In short-run equilibrium, a firm might make an economic profit, break even, or incur an economic loss.

Only one of them is a long-run equilibrium because firms can enter or exit the market.

Output, Price, and Profit
in the Long Run

Entry and Exit

New firms enter an industry in which existing firms make an economic profit.

Firms exit an industry in which they incur an economic loss.

Figure 12.9 shows the effects of entry and exit.

Output, Price, and Profit
in the Long Run

A Closer Look at Entry

When the market price is $25 a sweater, firms in the market are making economic profit.

Output, Price, and Profit
in the Long Run

New firms have an incentive to enter the market.

When they do, the market supply increases and the market price falls.

Output, Price, and Profit
in the Long Run

Firms enter as long as firms are making economic profits.

In the long run, the market price falls until firms are making zero economic profit.

Output, Price, and Profit
in the Long Run

A Closer Look at Exit

When the market price is $17 a sweater, firms in the market are incurring economic loss.

Output, Price, and Profit
in the Long Run

Firms have an incentive to exit the market.

When they do, the market supply decreases and the market price rises.

Output, Price, and Profit
in the Long Run

Firms exit as long as firms are incurring economic losses.

In the long run, the price continues to rise until firms make zero economic profit.

Output, Price, and Profit
in the Long Run

Changing Tastes and Advancing Technology

A Permanent Change in Demand

A decrease in demand shifts the market demand curve leftward.

The price falls and the quantity decreases.

Starting from long-run equilibrium, firms incur economic losses.

Figure 12.10 illustrates the effects of a permanent decrease in demand.

Watching the work of the invisible hand. The power of the market to make firms respond to consumers’ changing demands become visible to the student in this section. When you teach this material, do the analysis with a specific (and current/recent) example with which the students can identify. Computers and ISPs are good for an increase in demand. Audio tapes are good for a decrease in demand.

The market demand curve leftward, the market price falls, and each firm decreases the quantity it produces.

Changing Tastes and Advancing Technology

The market price is now below each firm’s minimum average total cost, so firms incur economic losses.

Changing Tastes and Advancing Technology

Economic losses induce some firms to exit in the long run, which decreases the market supply and the price starts to rise.

Changing Tastes and Advancing Technology

As the price rises, the quantity produced by all firms continues to decrease as more firms exit, but each firm remaining in the market starts to increase its quantity.

Changing Tastes and Advancing Technology

A new long-run equilibrium occurs when the price has risen to equal minimum average total cost. Firms make zero economic profits, and firms no longer exit the market.

Changing Tastes and Advancing Technology

The main difference between the initial and new long-run equilibrium is the number of firms in the market.

Fewer firms produce the equilibrium quantity.

Changing Tastes and Advancing Technology

A permanent increase in demand has the opposite effects to those just described and shown in Figure 12.10.

A permanent increase in demand shifts the demand curve rightward. The price rises and the quantity increases.

Economic profit induces entry, which increases short-run supply and shifts the short-run market supply curve rightward.

As the market supply increases, the price falls and the market quantity continues to increase.

Changing Tastes and Advancing Technology

With a falling price, each firm decreases its output as it moves along its marginal cost curve (supply curve).

A new long-run equilibrium occurs when the price has fallen to equal minimum average total cost.

Firms make zero economic profit, and firms have no incentive to enter the market.

The main difference between the initial and new long-run equilibrium is the number of firms. In the new equilibrium, a larger number of firms produce the equilibrium quantity.

Changing Tastes and Advancing Technology

External Economics and Diseconomies

The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies.

External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases.

External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases.

Changing Tastes and Advancing Technology

In the absence of external economies or external diseconomies, a firm’s costs remain constant as the market output changes.

Figure 12.11 illustrates the three possible cases and shows the long-run market supply curve.

The long-run market supply curve shows how the quantity supplied in a market varies as the market price varies after all the possible adjustments have been made, including changes in each firm’s plant and the number of firms in the market.

Changing Tastes and Advancing Technology

Figure 12.11(a) shows that in the absence of external economies or external diseconomies, an increase in demand does not change the price in the long run.

The long-run market supply curve LSA is horizontal.

Changing Tastes and Advancing Technology

Figure 12.11(b) shows that when external diseconomies are present, an increase in demand brings a higher price in the long run.

The long-run market supply curve LSB is upward sloping.

Changing Tastes and Advancing Technology

Figure 12.11(c) shows that when external economies are present, an increase in demand brings a lower price in the long run.

The long-run market supply curve LSC is downward sloping.

Changing Tastes and Advancing Technology

Technological Change

New technologies are constantly discovered that lower costs.

A new technology enables firms to produce at a lower average cost and a lower marginal cost—firms’ cost curves shift downward.

Firms that adopt the new technology make an economic profit.

Changing Tastes and Advancing Technology

New-technology firms enter and old-technology firms either exit or adopt the new technology.

Industry supply increases and the industry supply curve shifts rightward.

The price falls and the quantity increases.

Eventually, a new long-run equilibrium emerges in which all firms use the new technology, the price equals minimum average total cost, and each firm makes zero economic profit.

Changing Tastes and Advancing Technology

Competition and Efficiency

Efficient Use of Resources

Resources are used efficiently when no one can be made better off without making someone else worse off.

This situation arises when marginal social benefit equals marginal social cost.

Pulling it all together

In this section, you can show your students what they’ve learned and pull together the entire course to date.

Begin by reiterating the two primary goals of this chapter and then note that you are now dealing with the second goal.

Emphasize that the pressures of competition force self-interested firms to produce incredible long run results:

Each firm produces at the lowest possible average total cost –at the minimum point of the long run average cost curve,

Consumers pay the lowest possible price that keeps firms in business—P equals minimum ATC.

Each firm uses the least-cost technology,

Firms produce the efficient quantity—price, which equals marginal benefit equals marginal cost.

The forces of competition, which Adam Smith called an invisible hand, guide firms to produce output and charge prices that maximize the value of our scarce resources.

Choices, Equilibrium, and Efficiency

We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium.

Choices

A consumer’s demand curve shows how the best budget allocation changes as the price of a good changes.

So consumers get the most value out of their resources at all points along their demand curves.

With no external benefits, the market demand curve is the marginal social benefit curve.

Competition and Efficiency

A competitive firm’s supply curve shows how the profit-maximizing quantity changes as the price of a good changes.

So firms get the most value out of their resources at all points along their supply curves.

With no external cost, the market supply curve is the marginal social cost curve.

Competition and Efficiency

Equilibrium and Efficiency

In competitive equilibrium, resources are used efficiently—the quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost.

The gains from trade for consumers is measured by consumer surplus.

The gains from trade for producers is measured by producer surplus.

Total gains from trade equal total surplus.
In long-run equilibrium total surplus is maximized.

Competition and Efficiency

Figure 12.12 illustrates an efficient allocation of resources in a perfectly competitive market.

At the market price P*, each firm is producing the quantity q*at the lowest possible long-run average total cost.

Competition and Efficiency

Figure 12.12(b) shows the market.

Along the market demand curve D = MSB, consumers are efficient.

Along the market supply curve S = MSC, producers are efficient.

Competition and Efficiency

The quantity Q* and price P* are the competitive equilibrium values.

So competitive equilibrium is efficient.

Total surplus, the sum of consumer surplus and

producer surplus, is maximized.

Competition and Efficiency