Perfect Competition

Mr. Green’s Economics 2010

Dixie State College

Economics 2010 Home Page

Equal Opportunity Costs Suppose Mr. A is equally skilled at

two jobs: producing milk or selling insurance.

Suppose Mr. A is indifferent in his preference between selling insurance and producing milk.

Suppose his accountant tells him that his profit if he chooses to sell insurance will be $100,000 and his profit if he chooses to produce milk will also be $100,000.

Accounting Profit

The costs that are counted by accountants are the costs of the factors of production: rents, wages, interest

Revenue – Cost = Normal or Accounting Profit

Economists call these accounting costs Explicit Costs

Revenue – Explicit Costs = Normal or Accounting Profit

Divergent Opportunity Costs Suppose Mr. A is selling insurance

and earning $100,000 per year, and

Suppose demand for milk increases so that yearly profits in milk production rise to $120,000.

The opportunity cost (or implicit cost) of remaining is the insurance business is . . . .?

$20,000.

Economic Profit Normal or Accounting Profit =

Revenue – Explicit Costs Economic Profit = (Normal Profit in

Industry A) – (Normal Profit in Industry B)

Economic Profit = the Opportunity Cost(s) of Working in Industry A when compared to Industry B.

Industrial Organization Continuum: Degree of Competition

Perfect Competition

MonopolyOligopolyMonopolistic Competition

Many Firms One Firm

No Barriers to Entry Significant Barriers to Entry

Homogenous Product

Differentiated Product

Number of Firms Many small firms; therefore, no

single firm can effect the price. This makes the firms are price takers.

Only a few firms or one firm. therefore, each will have power to set or influence prices.

This makes the firms are price makers.

Homogenous Product If there is no difference between

the product(s) of one producer and those of another producer, the product is homogenous.

If the product(s) of one producer and those of another producer can be differentiated, the product is not homogenous.

Barriers to Entry and Exit Money? Expertise Sole Ownership

of a Resource Economies of

Scale

Network Barriers Patents and

Copyrights Licenses,

Regulations, Taxes, etc.

Market Structure

Perfect Competition

Monopolistic Competition Oligopoly Monopoly

# of Suppliers?

Homogenous Product?

Barriers to Entry and Exit?

Homogenous Product

Differentiated Product

Differentiated Product

No Barriers Brand Name Barriers

Economies of Scale Barriers

Significant Barriers

Many Sellers Many Sellers Few Sellers One Seller

Perfect Competition

Perfect Competition

Monopolistic Competition Oligopoly Monopoly

# of Suppliers?

Homogenous Product?

Barriers to Entry and Exit?

Homogenous Product

No Barriers

Price Takers

Many Sellers

The Price Taker Assumption

P

Qmilk

S

D

Qe

$6

P

Qmilk

D

Market Supply and Demand

Contented Cow Dairy’s Demand

Marginal Revenue

TR

0

1

2

3

4

5

6

7

6

6

6

6

6

6

6

6

0

6

12

18

24

30

36

42

6

6

6

6

6

MRQ P

6

6

Demand = Marginal Revenue

P

Qmilk

S

D

Qe

$6P = D = MR

P

Qmilk

Market Supply and Demand

Contented Cow Dairy’s Demand

Marginal Cost

AVC

Quantity

Cost or

Price

AFC

ATC

Quantity

Cost or

Price

AFC

AVCATC

MC

MC

Profit Maximization

P

Qmilk

$6P = D = MR

MC

2

$4

1

$3

Profit Maximization

P

Qmilk

$6P = D = MR

MC

2

$4$5

3

Profit Maximization

P

Qmilk

$6P = D = MR

MC

2

$4$5

3 5

$7

4

Profit Maximization

P

Qmilk

$6P = D = MR

MC

2

$4$5

3 4 5

$7

Profit Maximization

4 pounds of milk maximizes profit because at MR = MC the producer gets the most possible additional profit without incurring any loss.

Production in Perfect Competition Short Run

The Short-Run Shut-Down PointDerivation of the Supply Curve

Long RunProfit, Loss, and the Zero Profit

EquilibriumLong Run Supply Curve

Total Revenue

The Short Run Shut-Down Point

Quantity

Cost or Price

AVC

D=MR0

Q0

P0

P1

P2

P3

ATC

MC

Total Variable Cost

Total Revenue

Remaining Total Variable Cost

Total Fixed Cost

Result

At MR0, Average Variable Cost > Marginal Revenue and Rational Firms will Shut-Down

The Short Run Shut-Down Point

Quantity

Cost or Price

AVC

D=MR0

D=MR1

D=MR3

Q2

P0

P1

D=MR2P2

P3

MC

ATC

Total RevenueTotal Variable Cost

Total Fixed CostRemaining Total Revenue

Remaining Total Fixed Cost

Result

At MR0, Average Variable Cost > Marginal Revenue and Rational Firms will Shut-Down

At MR2, Average Variable Cost < Marginal Revenue and Rational Firms will Stay Active

The Short Run Shut-Down Point

Quantity

Cost or Price

D=MR0

D=MR2

D=MR3

Q1

P0

P2

P3

AVCATC

D=MR1P1

MC

Total RevenueAverage Variable Costs

Average Fixed Cost

Total Revenue

Result

At MR0, Average Variable Cost > Marginal Revenue and Rational Firms will Shut-Down

At MR1, Average Variable Cost = Marginal Revenue and Rational Firms can either Shut-Down or Stay Active.

At MR2, Average Variable Cost < Marginal Revenue and Rational Firms will Stay Active

The Short Run Shut-Down Point

Quantity

Cost or Price

AVC

D=MR1

Shut Down Point: AVC = MR

ATC

MC

P1

The Supply Curve

Quantity

Cost or Price

AVC

D=MR0

D=MR1

D=MR2

D=MR3

Q1 Q2Q3

P0

P1

P2

P3

= SupplyMC

ATC

Dynamics of a Price Increase

Qmilk

Cost or

PriceATC

MC

Individual Milk Producing Firm

MR1

MarketP1

Price

Quantity

Market for Milk

S

D1

Market

Q1

Q1

MR3MarketP3

D2

Market

Q3

Q3

Total RevenueTotal Cost

Qmilk

Cost or Price ATC

MC

Q3

Economic Profit

P3MR3

Economic Profit

The Opportunity Cost Suppose Mr. A is selling insurance

and earning $100,000 per year. According to the graph, there are

economic profits in milk. Assume these economic profits = $20,000.

Mr. A can earn $100,000 in insurance or $120,000 by switching to milk. The opportunity cost of staying in insurance is $20,000.

Economic Profit If there is easy entry, economic

profit will act like a magnet. People with the expertise and the

inclination to produce milk enter the milk industry.

These new suppliers will bid down the price.

Suppliers will continue to enter until there is no magnet.

Attraction of Profits

Qmilk

Cost or

Price ATC MC

Quantity

Price

S1

D1

Market for Milk Individual Milk Producing Firm

D2

Market

Q2

MR3

S2

Market

Q1

Q2

MR1

MarketP1

MarketP3MR2MarketP2

Total RevenueTotal Cost

Qmilk

Cost or Price ATC

MC

Economic Profit

Q2

P2MR2Economic Profit

P3MR3

Attraction of Profits

Qmilk

Cost or

Price ATC MC

Quantity

Price

S1

D1

Market for Milk Individual Milk Producing Firm

D2

MP3

MR3S2

Q1MQ4MQ1

MR1

MP1

MQ3 Q3

Competitive Equilibrium

MR = ATC Economic Profit = 0

Total RevenueTotal Cost

Qmilk

Cost or Price

ATC

MC

Competitive Equilibrium

Q1

ATC = MR Economic Profit = 0

MR1P1

Dynamics of a Price Decrease

Qmilk

Cost or Price ATC

MC

Individual Milk Producing Firm

MR1MarketP1

Price

Quantity

Market for Milk

S

D2

Market

Q1

Q1

MR3MarketP3

D1

Market

Q3

Q3

Total Revenue

Total Cost

Qmilk

Cost or Price ATC

MC

Q3

P3MR3

Economic Loss

P1 MR1Economic Loss

The Opportunity Cost Suppose Mr. A is earning $80,000 a

year producing milk. Suppose Mr. A could earn $100,000

selling insurance. The opportunity cost of staying in

milk production is $20,000. The economic loss shown on the graph is $20,000.

Economic Loss If there is easy exit, economic loss

will repulse milk producers. They will exit the milk industry for

other more profitable pursuits. This loss of suppliers will bid up the

price. Suppliers will continue to exit until

the repulsion ends.

Repulsion of Loss

Qmilk

Cost or Price ATC

MC

Individual Milk Producing Firm

MR1MP1

Price

Quantity

Market for Milk

D2

MQ2Q1

MR3MP3

D1

MQ3Q3

S1

S2

MP2MR2

Q2MQ1

P3MR3

Total ProfitTotal Cost

Qmilk

Cost or Price

ATC

MC

Q3

Economic Loss

P2MR2

Q2

Economic Loss

Repulsion of Loss

Qmilk

Cost or Price ATC

MC

Individual Milk Producing Firm

MR1MP1

Price

Quantity

Market for Milk

D2

MQ4Q1

MR3MP3

D1

MQ3Q3

S1

S2

Q2MQ1

Competitive Equilibrium

MR = ATC Economic Loss = 0

Total RevenueTotal Cost

Qmilk

Cost or Price

ATC

MC

Competitive Equilibrium

Q1

ATC = MR Economic Loss = 0

MR1P1

Perfect Competition

Perfect Competition

Monopolistic Competition Oligopoly Monopoly

# of Suppliers?

Homogenous Product?

Barriers to Entry and Exit?

Homogenous Product

No Barriers

Price Takers

Many Sellers

Zero Economic

Profit or Loss

Long Run Supply Curve

Quantity

Price

S1

D1

Market for Milk

D2

P2

Q3

S2

Q4Q1

P1 Long Run Supply Curve

The End