12712 Perfect Competition

8/6/2019 12712 Perfect Competition

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Perfect Competition Short RunPerfect Competition Short Run



A Perfectly CompetitiveA Perfectly CompetitiveMarketMarket

A perfectly competitive market mustmeet the following requirements:

Both buyers and sellers are pricetakers.

The number of firms is large.

There are no barriers to entry.

The firms¶ products are identical. There is complete information.



Perfect CompetitionPerfect Competition

Perfect competition is a firm behavior that occurswhen many firms produce identical products andentry is easy. Characteristics of perfectcompetition:

There are many sellers.

The products sold by the firms in theindustry are identical.

Entry into and exit from the market areeasy, and there are many potential entrants.

Buyers (consumers) and sellers (firms) haveperfect information.



Price TakerPrice Taker

A firm in a perfectly competitive market issaid to be a price taker because the price

of the product is determined by marketsupply and demand, and the individualfirm can do nothing to change that price.



The Necessary ConditionsThe Necessary Conditionsfor Perfect Competitionfor Perfect Competition


A price taker is a firm or individual whotakes the market price as given.

In most markets, households are pricetakers ± they accept the price offered in

stores.





The retailer is not perfectly competitive.

A retail store is not a price taker buta price maker.




The number of firms is large.

Large means that what one firm doeshas no bearing on what other firms do.

Any one firm's output is minuscule whencompared with the total market.





Barriers to entry are social, political, or economic impediments that preventother firms from entering the market.

Barriers sometimes take the form of

patents granted to produce a certaingood.





Technology may prevent some firmsfrom entering the market.

Social forces such as bankers onlylending to certain people may create

barriers.




The firms' products are identical.

This requirement means that each firm'soutput is indistinguishable from anycompetitor's product.




There is complete information.

Firms and consumers know all there isto know about the market ± prices, products, and available technology.

Any technological breakthrough would

be instantly known to all in the market.



Demand Curves for the FirmDemand Curves for the Firmand the Industryand the Industry

The demand curves facing the firm isdifferent from the industry demandcurve.

A perfectly competitive firm¶s demandschedule is perfectly elastic eventhough the demand curve for the

market is downward sloping.



Perfect Competitors¶ DemandPerfect Competitors¶ DemandCurveCurve

The result is that the individual firmperceives the demand curve forits product as being perfectlyhorizontal.



Market supply

Marketdemand

1,000 3,000

Price

$10

8

6

42

0Quantity

Market Firm

Individual firm

demand

Market Demand VersusMarket Demand VersusIndividual Firm Demand CurveIndividual Firm Demand Curve

10 20 30

Price

$10

8

6

42

0Quantity



Market Supply and DemandMarket Supply and Demandand Singleand Single--Firm DemandFirm Demand



Profit MaximizationProfit Maximization

The firm has to decide whether toproduce at all, and if so what output toproduce

The firm will produce in the short run solong as its variable costs can be covered

Assuming the firm produces at all, the

profit maximizing output is where there isthe maximum excess of TR over TC orwhere MR = MC



Profit Maximum: TR and TCProfit Maximum: TR and TC

TC

TR

Q¶ Q´

Economic Profit$

Q

Q

Profit

Loss0 Q¶ Q´Q* Profit/Loss

Profit Max



Profit Maximum: MR and MCProfit Maximum: MR and MC

Why does MC = MR imply

profit max?

What would happen to TR

and TC if output

went up or down by a unit?

Q

$

MR P

MC

Q*



Profit in the Short RunProfit in the Short Run

P

Q*

ATC

MR

Economic

profit

$

Q

MC



Cont«Cont«

Q

MC

ATC

MR

Q*

$

P

Normal profit

or break even



Economic Loss in the ShortEconomic Loss in the ShortRunRun

MR P

ATC

MC

Q

$

Q*Economic loss

Firm will produce Q* as long as P>AVC



Firm¶s Short Run SupplyFirm¶s Short Run SupplyCurveCurve

The firm¶s short run supply curve willbe its MC curve above its AVC curve

If P is equal to or grater than Min AVCthe firm will produce where P = MR =MC

If P < Min AVC the firm¶s loss

minimizing strategy is to shut down.Loss will equal TFC



Firm¶s Short Run SupplyFirm¶s Short Run SupplyCurveCurve

MC

P

P¶

P´

Q Q¶ Q´

MR

MR¶

MR´

AVC

ATC

Q

$

Shut down point

Break even or

normal profit

point



Cont«Cont«

At prices below P the firm will shutdown

At prices between P and P¶ the firmwill

produce where MC=MR at aneconomic loss

At prices above P¶ the firm willproduce where

MC=MR at an economic profit



Market Supply CurveMarket Supply Curve

We can now d erive the market supplycurve

The supply curve of each firm is itsMC curve above its min AVC point

The market supply curve is thehorizontal sum of the supply curves of

all the firms in the industry



Short Run Equilibrium of theShort Run Equilibrium of theMarket and FirmMarket and Firm

Market demand curve is the horizontalsum of all the demand curves of individuals

Short run market supply curve is thehorizontal sum of all the short runsupply curves of all the firms currently

in the industry Market price and quantity is determined

by D = S

Each individual firm will produce at its

profit max point of MR = MC



SR Equilibrium of MarketSR Equilibrium of Marketand Firmand Firm

Market equilibrium

S = hMC

D = hDi

P*

Q*Q

P



Equilibrium of the firmEquilibrium of the firm

ATC

MC

q

P*MR

q*0

p



Shifts in Demand in theShifts in Demand in theShort RunShort Run

Shifts in demand will create amovement along the market shortrun supply curve, changing market

price

Each individual firm will adjust outputto its new profit max level as price

changes, moving along its own shortrun supply curve



Long Run AdjustmentsLong Run Adjustments

In the long run capital is not fixed

Firms can change the size of their plants andmove along their LAC curves

Firms can enter or leave the industry. Theywill enter if there is economic profit andleave if they are suffering economic losses

If firms change size or the number of firmsin the industry changes the short runindustry supply curve will shift

What conditions must hold for a perfectlycompetitive industry to be in long runequilibrium?



Long Run EquilibriumLong Run Equilibrium

Market price must adjust (via shifts in theshort run supply curve) until all firms are just making normal profit

With normal profit there is no economicprofit to attract new entrants and noeconomic losses to create exit

Also, for their to be no prospect of economic profit, price must equal minimumLAC

Otherwise firms could make economicprofit by changing their plant size whichwould shift the SR supply curve of theindustry



Long Run Equilibrium forLong Run Equilibrium forMarket and FirmMarket and Firm

S = h

SMC

D = hDi

Q*

P*

Q

P



Cont««.Cont««.

MR

LACSMCATC

q*

P*

P

Q



Long Run Supply CurveLong Run Supply Curve

S

D D¶

Q Q¶

P

P¶

S¶

LRS

Q

P



Cont«Cont«

D shifts to D¶ , raising market price to P¶.This will create excess profit for firmsattracting new entrants and shifting S to S¶

where all economic profit is againeliminated and new entry stops . Thisdiagram shows a constant cost industry.Long run supply curve is horizontal



Possible Long Run SupplyPossible Long Run SupplyCurvesCurves

Constant cost industry -- horizontal LRS.Changes in the size of the industry do notaffect firms¶ costs of production

Increasing cost industry ± upward slopingLRS. As an industry grows a factor pricerises as a result, increasing costs for allfirms

Decreasing cost industry ± downwardsloping LRS. As an industry grows a factorprice falls as a result, decreasing costs forall firms

Technological change shift s the LRS



Are Competitive MarketsAre Competitive MarketsEfficient?Efficient?

In competitive equilibrium price is such that D = S

The market D curve is the sum of individualdemand curves that can be interpreted as

willingness to pay or marginal benefit curves The market supply curve is the sum of the MC

curves of all firms and so can be seen as themarginal opportunity cost of production curve

Competitive equilibrium is economicallyefficient (maximizes social surplus) providedall costs and benefits are reflected in themarket D and S curves



Economic InefficienciesEconomic Inefficiencies

The efficient allocation may not beachieved even in competitive markets

Not all resources may be privately owned

(open access resources) It may not be possible for firms to capture

peoples¶ willingness to pay (public goods, external benefits)

Not all social costs may be reflected in theprices firms pay for factors of production(external costs)

Economic inefficiencies may also arise fromlack of competition --Monopoly



Producer SurplusProducer Surplus

The Producer Surplus for a firm is thedifference between the amount of revenue the firm receives at a

particular output level minus theminimum amount it would accept toproduce that output.

d S l fd S l f



Producer Surplus for aProducer Surplus for acompetitive firm.competitive firm.

Price

MC

$/Q

QQ*

Total revenue

Total (variable)

cost

Producer

surplus

12712 Perfect Competition

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