Ch07 cmba 401

Slides by John F. Hall

Animations by Anthony ZambelliINTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 7 / PERFECT COMPETITION©2005, South-Western/Thomson Learning

Chapter 7

Perfect Competition

Lieberman & Hall; Introduction to Economics, 2005 2

Perfect Competition To determine structure of any particular market, we begin by

asking How many buyers and sellers are there in the market? Is each seller offering a standardized product, more or less

indistinguishable from that offered by other sellers• Or are there significant differences between the products of different

firms? Are there any barriers to entry or exit, or can outsiders easily enter

and leave this market? Answers to these questions help us to classify a market into

one of four basic types Perfect competition Monopoly Monopolistic Oligopoly


The Three Requirements of Perfect Competition

Large numbers of buyers and sellers, and Each buys or sells only a tiny fraction of

the total quantity in the marketSellers offer a standardized productSellers can easily enter into or exit from

market


A Large Number of Buyers and Sellers

In perfect competition, there must be many buyers and sellersHow many?

•Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells


A Standardized Product Offered by Sellers

Buyers do not perceive significant differences between products of one seller and anotherFor instance, buyers of wheat do not prefer

one farmer’s wheat over another


Easy Entry into and Exit from the Market

Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and establish contacts with customers But perfectly competitive market has no significant barriers to

discourage new entrants• Any firm wishing to enter can do business on the same terms as firms

that are already there In many markets there are significant barriers to entry

Legal barriers Existing sellers have an important advantage that new entrants can

not duplicate• Brand loyalty enjoyed by existing producers would require a new entrant

to wrest customers away from existing firms Significant economies of scale may give existing firms a cost

advantage over new entrants


Easy Entry into and Exit from the Market

Perfect competition is also characterized by easy exit A firm suffering a long-run loss must be able to

sell off its plant and equipment and leave the industry for good, without obstacles

Significant barriers to entry and exit can completely change the environment in which trading takes place


Is Perfect Competition Realistic? Assumptions market must satisfy to be perfectly competitive

are rather restrictive In vast majority of markets, one or more of assumptions of

perfect competition will, in a strict sense, be violated Yet when economists look at real-world markets, they use perfect

competition more often than any other market structure Why is this?

Model of perfect competition is powerful Many markets—while not strictly perfectly competitive—come

reasonably close We can even—with some caution—use model to analyze

markets that violate all three assumptions Perfect competition can approximate conditions and yield

accurate-enough predictions in a wide variety of markets


Figure 1: The Competitive Industry and Firm

Ounces of Gold per Day

Price per Ounce

D

$400

S

Market

Demand Curve Facing

the Firm

$400

Firm

1. The intersection of the market supply and the market demand curve…

3. The typical firm can sell all it wants at the market price…


Price per Ounce

2. determine the equilibrium market price

4. so it faces a horizontal demand curve


Goals and Constraints of the Competitive Firm

Perfectly competitive firm faces a cost constraint like any other firm

Cost of producing any given level of output depends on Firm’s production technology Prices it must pay for its inputs


The Demand Curve Facing a Perfectly Competitive Firm

Panel (b) of Figure 1 shows demand curve facing Small Time Gold Mines Notice special shape of this curve

• It’s horizontal, or infinitely price elastic

Why should this be? In perfect competition output is standardized No matter how much a firm decides to produce, it

cannot make a noticeable difference in market quantity supplied • So cannot affect market price


The Demand Curve Facing a Perfectly Competitive Firm

Means Small Time has no control over the price of its output Simply accepts market price as given

• In perfect competition, firm is a price taker Treats the price of its output as given and beyond its control

Since a competitive firm takes the market price as given Its only decision is how much output to produce

and sell


Cost and Revenue Data for a Competitive Firm

For a competitive firm, marginal revenue at each quantity is the same as the market price

For this reason, marginal revenue curve and demand curve facing firm are the same A horizontal line at the market price


Figure 2(a): Profit Maximization in Perfect Competition

TR

550

$2,800

2,100

TC

Slope = 400


Dollars

1 2 3 4 5 6 7 8 9 10

Maximum Profit per Day = $700


Figure 2(b): Profit Maximization in Perfect Competition

MC

$400 D = MR


Dollars

1 2 3 4 5 6 7 8 9 10


The Total Revenue and Total Cost Approach

Most direct way of viewing firm’s search for the profit-maximizing output level

At each output level, subtract total cost from total revenue to get total profit at that output levelTotal Profit = TR - TC


The Marginal Revenue and Marginal Cost Approach

Firm should continue to increase output as long as marginal revenue > marginal cost

Remember that profit-maximizing output is found where MC curve crosses MR curve from below

Finding the profit-maximizing output level for a competitive firm requires no new concepts or techniques


Measuring Total Profit Start with firm’s profit per unit

Revenue it gets on each unit minus cost per unit• Revenue per unit is the price (P) of the firm’s output, and cost per

unit is our familiar ATC, so we can write Profit per unit = P – ATC

Firm earns a profit whenever P > ATC Its total profit at the best output level equals area of a

rectangle with height equal to distance between P and ATC, and width equal to level of output

A firm suffers a loss whenever P < ATC at the best level of output Its total loss equals area of a rectangle

• Height equals distance between P and ATC• Width equals level of output


Figure 3(a): Measuring Profit or Loss

$400300

Profit per Ounce ($100)

d = MR

MC

ATC

Economic Profit


Dollars

1 2 3 4 5 6 7 8


Figure 3(a): Measuring Profit or Loss

MC

ATC

d = MR$300

200

Loss per Ounce ($100)

Economic Loss


Dollars

1 2 3 4 5 6 7 8


The Firm’s Short-Run Supply Curve

A competitive firm is a price taker Takes market price as given and then decides how much

output it will produce at that price Profit-maximizing output level is always found by

traveling from the price, across to the firm’s MC curve, and then down to the horizontal axis, or As price of output changes, firm will slide along its MC

curve in deciding how much to produce Exception

If the firm is suffering a loss large enough to justify shutting down

• It will not produce along its MC curve• It will produce zero units instead


Figure 4: Short-Run Supply Under Perfect Competition

0.50

1,0002,000

4,0005,000

7,000

1.00

2.00

$3.50

2.50

MCATC

d1=MR1

AVC

(a)

Firm's Supply Curve

0.50

2,0004,000

5,000

7,000

1.00

2.00

$3.50

2.50

(b)

d2=MR2

d3=MR3

d4=MR4

d5=MR5

Bushels per Year

Dollars Price per Bushel

Bushels per Year


The Shutdown Price Price at which a firm is indifferent between producing and

shutting down Can summarize all of this information in a single curve—

firm’s supply curve Tells us how much output the firm will produce at any price

Supply curve has two parts For all prices above minimum point on its AVC curve, supply curve

coincides with MC curve For all prices below minimum point on AVC curve, firm will shut

down• So its supply curve is a vertical line segment at zero units of output

For all prices below $1—the shutdown price—output is zero and the supply curve coincides with vertical axis


Competitive Markets in the Short- Run

Short-run is a time period too short for firm to vary all of its inputsQuantity of at least one input remains fixed

Let’s extend concept of short-run from firm to market as a whole

Conclusion In short-run, number of firms in industry is

fixed


The (Short-Run) Market Supply Curve

Once we know how to find supply curve of each individual firm in a market Can easily determine the short-run market supply curve

• Shows amount of output that all sellers in market will offer at each price

To obtain market supply curve sum quantities of output supplied by all firms in market at each price

As we move along this curve, we are assuming that two things are constant Fixed inputs of each firm Number of firms in market


Short-Run Equilibrium

How does a perfectly competitive market achieve equilibrium? In perfect competition, market sums buying and

selling preferences of individual consumers and producers, and determines market price• Each buyer and seller then takes market price as

given Each is able to buy or sell desired quantity

Competitive firms can earn an economic profit or suffer an economic loss


Figure 6: Perfect Competition

Quantity Demanded at

Different Prices

Quantity Supplied at

Different Prices

Quantity Supplied by Each Firm

Quantity Demanded by

Each Consumer

Individual Demand

Curve

Individual Supply Curve

Quantity Demanded by All Consumers at

Different Prices

Quantity Supplied by All Firms at Different

Prices

Market Demand

Curve

Market Supply Curve

P S

D

Q

Market Equilibrium

Added together Added together


Figure 7: Short-Run Equilibrium in Perfect Competition

400,000 700,000

2.00

$3.50

S

D1

D2

MC

d1

d2

ATC

7,0004,000

2.00

$3.50

3. If the demand curve shifts to D2 and the market equilibrium moves here . . .

4. the typical firm operates here and suffers a short-run loss.

2. the typical firm operates here, earning economic profit in the short run.

1. When the demand curve is D1 and market equilibrium is here . . .

Profit per Bushel at p = $3.50

Price per Bushel

Market

Bushels per Year

DollarsFirm

Bushels per Year

Loss per Bushel at p = $2


Profit and Loss and the Long Run

In a competitive market, economic profit and loss are the forces driving long-run change Expectation of continued economic profit (losses) causes outsiders

(insiders) to enter (exit) the market In real world entry and exit occur literally every day

In some cases, we see entry occur through formation of an entirely new firm

Entry can also occur when an existing firm adds a new product to its line

Exit can occur in different ways Firm may go out of business entirely, selling off its assets and

freeing itself once and for all from all costs Firm switches out of a particular product line, even as it continues to

produce other things


From Short-Run Profit to Long-Run Equilibrium

As we enter long-run, much will change Economic profit will attract new entrants

• Increasing number of firms in market As number of firms increases, market supply curve will shift

rightward causing several things to happen Market price begins to fall As market price falls, demand curve facing each firm

shifts downward Each firm—striving as always to maximize profit—will

slide down its marginal cost curve, decreasing output


From Short-Run Profit to Long-Run Equilibrium

This process of adjustment—in the market and the firm—continues until…well, until when? When the reason for entry—positive profit—no longer

exits Requires market supply curve to shift rightward enough,

and the price to fall enough• So that each existing firm is earning zero economic profit

In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero


Figure 8(a/b): From Short-Run Profit To Long-Run Equilibrium

S1

d1ATC

MC

$4.50

With initial supply curve S1, market price is $4.50…

$4.50

900,000 9,000

So each firm earns an economic profit.

AA

Price per Bushel

Market

Bushels per Year

Dollars

Firm

Bushels per Year

D


Figure 8(c/d): From Short-Run Profit To Long-Run Equilibrium

S1

d1ATC

MC

$4.50

Profit attracts entry, shifting the supply curve rightward…

$4.50

900,000 9,0005,000

until market price falls to $2.50 and each firm earns zero economic profit.

S2

d1

AA

2.502.50EE

Market Firm

Price per Bushel

Bushels per Year

Dollars

Bushels per Year

D

1,200,000


From Short-Run Loss to Long-Run Equilibrium

What if we begin from a position of loss? Same type of adjustments will occur, only in the opposite

direction

In a competitive market, economic losses continue to cause exit until losses are reduced to zero

When there are no significant barriers to exit Economic loss will eventually drive firms from the

industry• Raising market price until typical firm breaks even again


Distinguishing Short-Run from Long-Run Outcomes

In short-run equilibrium, competitive firms can earn profits or suffer losses In long-run equilibrium, after entry or exit has occurred, economic

profit is always zero When economists look at a market, they automatically think

of short-run versus long-run Choose the period more appropriate for the question at hand

Basic Principle #7: Short-Run versus Long-Run Outcomes Markets behave differently in the short-run and the long run In solving a problem, we must always know which of these time

horizons we are analyzing


The Notion of Zero Profit in Perfect Competition

We have not yet discussed plant size of competitive firm

The same forces—entry and exit—that cause all firms to earn zero economic profit also ensure In long-run equilibrium, every competitive firm

will select its plant size and output level so that it operates at minimum point of its LRATC curve


Perfect Competition and Plant Size

Figure 9(a) illustrates a firm in a perfectly competitive market But panel (a) does not show a true long-run equilibrium How do we know this?

• In long-run typical firm will want to expand• Why?

Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit

By expanding firm could potentially earn an economic profit

• Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset

Entry and expansion must continue in this market until the price falls to P* Because only then will each firm—doing the best that it can do—

earn zero economic profit


Figure 9: Perfect Competition and Plant Size

P1

q1

d1 = MR1

LRATCMC1 ATC1

E

d2 = MR2

LRATC

MC2 ATC2

P*

q*4. and all firms earn zero economic profit and produce at minimum LRATC.

.

Dollars Dollars

Output per Period

Output per Period

3. As all firms increase plant size and output, market price falls to its lowest possible level . . .

1. With its current plant and ATC curve, this firm earns zero economic profit.

2. The firm could earn positive profit with a larger plant, producing here.


A Summary of the Competitive Firm in the Long-Run

Can put it all together with a very simple statement At each competitive firm in long-run equilibrium

• P = MC = minimum ATC = minimum LRATC

In figure 9(b), this equality is satisfied when the typical firm produces at point E Where its demand, marginal cost, ATC, and LRATC

curves all intersect In perfect competition, consumers are getting the

best deal they could possibly get


A Change in Demand Short-run impact of an increase in demand is

Rise in market price Rise in market quantity Economic profits

What happens in long-run after demand curve shifts rightward? Market equilibrium will move from point A to point C

Long-run supply curve Curve indicating quantity of output that all sellers in a

market will produce at different prices• After all long-run adjustments have taken place


Figure 10: An Increasing-Cost Industry

INITIAL EQUILIBRIUM

D1

S1

AP1

Q1

P1

q1

MC

A

ATC1

d1 = MR1

Output per Period

MarketDollars

Firm

Output per Period

Price per Unit


Figure 10: An Increasing-Cost Industry

NEW EQUILIBRIUM

MC

ATC1

DollarsFirm

P1

q1

Ad1 = MR1

Output per Period

Market

S1

Output per Period

Price per Unit

D1

AP1

Q1

dSR = MRSR

d2 = MR2P2

PSR

P2

PSR ATC2C

BB

C

QSR Q2q1 q1

S2

SLR

D2


Increasing, Decreasing, and Constant Cost Industries

Increase in demand for inputs causes price of those inputs to rise

This type of industry (which is the most common) is called an increasing cost industry Entry causes input prices to rise

• Shifts up typical firm’s ATC curve Raises market price at which firms earn zero economic profit

As a result, long-run supply curve slopes upward


Increasing, Decreasing, and Constant Cost Industries

Other possibilities Industry might use such a small percentage of total inputs that—

even as new firms enter—there is no noticeable effect on input prices

• Called a constant cost industry Entry has no effect on input prices, so typical firm’s ATC curve stays put

Market price at which firms earn zero economic profit does not change Long-run supply curve is horizontal

Decreasing cost industry, in which entry by new firms actually decreases input prices

• Entry causes input prices to fall Causes typical firm’s ATC curve to shift downward

Lowers market price at which firms earn zero economic profit As a result, long-run supply curve slopes downward


Market Signals and the Economy

In real world, demand curves for different goods and services are constantly shifting

As demand increases or decreases in a market, prices change

Economy is driven to produce whatever collection of goods consumers prefer

In a market economy, price changes act as market signals, ensuring that pattern of production matches pattern of consumer demands When demand increases, a rise in price signals firms to enter

market, increasing industry output When demand decreases, a fall in price signals firms to exit market,

decreasing industry output


Market Signals and the Economy

Market signal Price changes that cause firms to change their

production to more closely match consumer demand No single person or government agency directs this

process This is what Adam Smith meant when he suggested that

individual decision makers act for the overall benefit of society

• Even though, as individuals, they are merely trying to satisfy their own desires

• As if guided by an invisible hand

Ch07 cmba 401

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