Chapter 23

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 23

Perfect Competition

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 23-2

Introduction

Most gold mines in California ceased operations by the 1960s.

Since 2007, a number of mining companies have modernized some of these gold mines and begun extracting gold once again.

To understand why these gold mines were closed and reopened again, you must learn about the theory of perfect competition—the topic of this chapter.


Learning Objectives

• Identify the characteristics of a perfectly competitive market structure

• Discuss the process by which a perfectly competitive firm decides how much output to produce

• Understand how the short-run supply curve for a perfectly competitive firm is determined


Learning Objectives (cont'd)

• Explain how the equilibrium price is determined in a perfectly competitive market

• Describe what factors induce firms to enter or exit a perfectly competitive industry

• Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve


Chapter Outline

• Characteristics of a Perfectly Competitive Market Structure

• The Demand Curve of the Perfect Competitor

• How Much Should the Perfect Competitor Produce?

• Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production

• Short-Run Profits


Chapter Outline (cont'd)

• The Short-Run Breakeven Price and the Short-Run Shutdown Price

• The Supply Curve for a Perfectly Competitive Industry

• Price Determination Under Perfect Competition

• The Long-Run Industry Situation: Exit and Entry

• Long-Run Equilibrium

• Competitive Pricing: Marginal Cost Pricing


Did You Know That ...

• More than 1,600 U.S. auto dealerships closed during 2009?

• Ease of exit from an industry is a fundamental characteristic of the theory of perfect competition —the topic of this chapter.


Characteristics of a Perfectly Competitive Market Structure

• Perfect Competition

– A market structure in which the decisions of individual buyers and sellers have no effect on market price


Characteristics of a Perfectly Competitive Market Structure (cont'd)

• Perfectly Competitive Firm

– A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells



• Price Taker

– A competitive firm that must take the price of its product as given because the firm cannot influence its price



• Why a perfect competitor is a price taker

1.Large number of buyers and sellers

2.Homogenous products are perfect substitutes

3.Both buyers and sellers have equal access to information

4.No barriers to entry or exit (any firm can enter or leave the industry without serious impediments)


The Demand Curve of the Perfect Competitor

• Question

– If the perfectly competitive firm is a price taker, who or what sets the price?


The Demand Curve of the Perfect Competitor (cont'd)

• The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes.

– Will sell all units for $5

– Will not be able to sell at a higher price

– Will face a perfectly elastic demand curve at the going market price


Figure 23-1 The Demand Curve for a Producer of Titanium Batteries


How Much Should the Perfect Competitor Produce?

• Perfect competitor accepts price as given– Firm raises price, it sells nothing– Firm lowers its price, it earns less revenues than it otherwise would

• Perfect competitor has to decide how much to produce– Firm uses profit-maximization model


How Much Should the Perfect Competitor Produce? (cont'd)

• The model assumes that firms attempt to maximize their total profits.– The positive difference between total revenues and total costs

• The model also assumes firms seek to minimize losses– When total revenues may be less than total costs



• Total Revenues

– The price per unit times the total quantity sold

– The same as total receipts from the sale of output



P is determined by the market in perfect competitionQ is determined by the producer to maximize profit

TR = P x Q

Profit = Total revenue (TR) – Total cost (TC)

TC = TFC + TVC



• For the perfect competitor, price is also equal to average revenue (AR) because

• The demand curve is the average revenue curve

AR = = = PTRQ

PQQ


Figure 23-2 Profit Maximization, Panel (a)


TotalOutput/Sales/ Total Market Total Total

day Costs Price Revenue Profit

0 $10 $5 $0 $10

1 15 5 5 10

2 18 5 10 8

3 20 5 15 5

4 21 5 20 1

5 23 5 25 2

6 26 5 30 4

7 30 5 35 5

8 35 5 40 5

9 41 5 45 4

10 48 5 50 2

11 56 5 55 1

Figure 23-2 Profit Maximization, Panel (b)


Figure 23-2 Profit Maximization, Panel (c)

TotalOutput/Sales/ Market Marginal Marginal

day Price Cost Revenue

0 $5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5

9 5

10 5

11 5

$5 $5

3 5

2 5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5



• Profit-Maximizing Rate of Production

– The rate of production that maximizes total profits, or the difference between total revenues and total costs

– Also, the rate of production at which marginal revenue equals marginal cost


Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production

• Marginal Revenue – The change in total revenues divided by the change in output

MR = change in TRchange in Q


Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont’d)

• Marginal Cost – The change in total cost divided by the change in output

MR = change in TCchange in Q


Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont'd)

• Profit maximization occurs at the rate of output at which – marginal revenue equals marginal cost

MR = MC


Short-Run Profits

• To find out what our competitive individual secure digital cards producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost


Short-Run Profits (cont'd)

• From Figure 23-2 previously, if we have production and sales of seven Titanium batteries, TR = $35, TC = $30, and profit = $5 per hour.

• Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 23-3.


Figure 23-3 Measuring Total Profits

•Profits are maximized where MR = MC

•This occurs at Q = 7.5 units



• Graphical depiction of maximum profits and graphical depiction of minimum losses

– The height of the rectangular box in the previous figure represents profits per unit

– The length represents the amount of units produced

– When we multiply these two quantities, we get total economic profits



• Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q

• In the short run, the perfectly competitive firm can make either economic profits or economic losses


•Losses are minimized where MR = MC

•This occurs at Q = 5.5 units

Figure 23-4 Minimization of Short-Run Losses


Short-Run Profits (cont’d)

• We see in the previous Figure 23-4 that the marginal revenue (d2) curve is intersected (from below) by the marginal cost curve at an output rate of 5 batteries per hour

• The firm is clearly not making profits because average total costs at that output rate are greater than the price of $3 per battery.

• The losses are shown in the shaded area.


The Short-Run Break-Even Price and the Short-Run Shutdown Price

• What do you think?

– Would you continue to produce if you were incurring a loss?• In the short run?

• In the long run?


The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)

• As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce.

• A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.



• As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.



• Short-Run Break-Even Price– The price at which a firm’s total revenues equal its total costs

– At the break-even price, the firm is just making a normal rate of return on its capital investment (it’s covering its explicit and implicit costs).

• Short-Run Shutdown Price– The price that just covers average variable costs

– It occurs just below the intersection of the marginal cost curve and the average variable cost curve.


Figure 23-5 Short-Run Break-Even and Shutdown Prices



• The meaning of zero economic profits• Question

– Why produce if you are not making a profit?

• Answer– Distinguish between economic profits and accounting profits

– Remember when economic profits are zero a firm can still have positive accounting profits


Example: Why Firms Stubbornly Produced Aluminum in the Late 2000s

• Between the summer of 2008 and the end of the winter of 2009, the market clearing price of aluminum fell by more than 50 percent.

• Meanwhile, almost all aluminum firms maintained their production operations until early in the spring of 2009.

• They did so because, even though the equilibrium price fell below the short-run break-even price, for several months the price remained above the short-run shutdown price.


The Supply Curve for a Perfectly Competitive Industry

• Question– What does the short-run supply curve for the individual firm look like?

• Answer– The firm’s short-run supply curve in a competitive industry is its marginal cost curve at and above the point of intersection with the average variable cost curve


Figure 23-6 The Individual Firm’s Short-Run Supply Curve

•Given the price, the quantity is determined where MC = MR

•Short-run supply = MC above minimum AVC


The Supply Curve for a Perfectly Competitive Industry (cont'd)

• The Industry Supply Curve

– The locus of points showing the minimum prices at which given quantities will be forthcoming

– Also called the market supply curve


Figure 23-7 Deriving the Industry Supply Curve


The Supply Curve for a Perfectly Competitive Industry (cont'd)

• Factors that influence the industry supply curve (determinants of supply)

– Firm’s productivity

– Factor costs (wages, prices of raw materials)

– Taxes and subsidies

– Number of sellers


Price Determination Under Perfect Competition

• Question– How is the market, or “going,” price established in a competitive market?

• Answer– This price is established by the interaction of all the suppliers (firms) and all the demanders (consumers)


Price Determination Under Perfect Competition (cont'd)

• The competitive price is determined by the intersection of the market demand curve and the market supply curve

– The market supply curve is equal to the horizontal summation of the supply curves of the individual firms


Pe and Qe determined by

the interaction of the industry S and market D

Pe is the price

the firm must take

Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (a)


Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (b)

•Given Pe, firm produces qe where MC = MR

If AC = AC1, break-even

•If AC = AC2, losses

•If AC = AC3, economic profit


The Long-Run Industry Situation: Exit and Entry

• Profits and losses act as signals for resources to enter an industry or to leave an industry


The Long-Run Industry Situation: Exit and Entry (cont'd)

• Signals

– Compact ways of conveying to economic decision makers information needed to make decisions

– An effective signal not only conveys information but also provides the incentive to react appropriately



• Exit and entry of firms

– Economic profits • Signal resources to enter the market

– Economic losses • Signal resources to exit the market



• Allocation of capital and market signals

– Price system allocates capital according to the relative expected rates of return on alternative investments.

– Investors and other suppliers of resources respond to market signals about their highest-valued opportunities.



• Tendency toward equilibrium (note that firms are adjusting all of the time)

– At break-even, resources will not enter or exit the market

– In competitive long-run equilibrium, firms will make zero economic profits



• Long-Run Industry Supply Curve

– A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits



• Constant-Cost Industry

– An industry whose total output can be increased without an increase in long-run per-unit costs

– Its long-run supply curve is horizontal.


Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (a)



• Increasing-Cost Industry

– An industry in which an increase in industry output is accompanied by an increase in long-run per unit costs

– Its long-run industry supply curve slopes upward


Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (b)



• Decreasing-Cost Industry

– An industry in which an increase in industry output leads to a reduction in long-run per-unit costs

– Its long-run industry supply curve slopes downward.


Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (c)


Long-Run Equilibrium

• In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized

• In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal


Figure 23-10 Long-Run Firm Competitive Equilibrium


Why Not … eliminate economic profits entirely?

• If companies were prohibited from earning more than zero economic profits, entrepreneurs would have little incentive to try new ways of doing things in an effort to reduce costs and gain profits.

• There would also be no incentive for new firms to enter an industry experiencing growing demand.

• Thus, society benefits from the market signals created when firms experience positive short-run economic profits.


Competitive Pricing: Marginal Cost Pricing

• Marginal Cost Pricing

– A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question

– The opportunity cost is the marginal cost to society.


Competitive Pricing: Marginal Cost Pricing (cont'd)

• Market Failure

– A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity


You Are There: The Coal Mining Industry Confronts a Changing Cost Structure

• In past decades, coal mining was a decreasing-cost industry and the market clearing price of coal steadily declined relative to other goods and services.

• Today, coal mining has become an increasing-cost industry as miners have to dig deeper and move more earth to extract coals from aging mines.

• So, in the long run, the equilibrium price will rise as the demand for coal increases.


Issues & Applications: A Higher Price Sets Off a New California Gold Rush

• Since 2000, both the current dollar and the inflation-adjusted price of gold have more than tripled.

• As the theory of perfect competition predicts, the increase in the price of gold has touched off renewed interest by mining firms in trying to extract gold from California mines abandoned decades ago.


Issues & Applications: A Higher Price Sets Off a New California Gold Rush (cont’d)

• The gold mining industry satisfies the key characteristics of perfect competition:– Units of each type of gold are homogeneous, even though it has different qualities

– Many mining firms have the technology to extract gold from earth

– The potential output of each mining firm is small relative to total gold production

– It is easy to enter or leave the industry


Figure 23-11 Index Measures of the Current-Dollar and Inflation-Adjusted Prices of Gold


Summary Discussion of Learning Objectives

• The characteristics of a perfectly competitive market structure

1.Large number of buyers and sellers

2.Homogeneous product

3.Buyers and sellers have equal access to information

4.No barriers to entry and exit


Summary Discussion of Learning Objectives (cont'd)

• How a perfectly competitive firm decides how much to produce

– Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve



• The short-run supply curve of a perfectly competitive firm – The rising part of the marginal cost curve above minimum average variable cost

• The equilibrium price in a perfectly competitive market– A price at which the total amount of output supplied by all firms is equal to the total amount of output demanded by all buyers



• Incentives to enter or exit a perfectly competitive industry

– Economic profits induce entry of new firms

– Economic losses will induce firms to exit the industry



• The long-run industry supply curve and constant-, increasing-, and decreasing-cost industries

– The relationship between price and quantity after firms have been able to enter or exit the industry

– Constant-cost industry• Horizontal long-run supply curve

– Increasing-cost industry• Upward-sloping long-run supply curve

– Decreasing-cost industry• Downward-sloping long-run supply curve

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Chapter 23