Perfect Competition in the Long Run
You got to know when to hold 'em, know when to fold 'em,Know when to walk away and know when to run.
-Kenny Rogers
Slide 1 of 19
Recall the characteristics of perfect competition
Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly
At the absolute end of this spectrum, competition is fierce.
Characteristics of perfect competition:
Product is homogeneous
This means that each producer makes a very similar product. Examples include blue crab
fisherman and wheat farmers, whose good are similar.There are many, many buyers and sellers
and each firm constitutes a very small fraction of the market
Firms have no control over price
There are no barriers to entry
This means that producers have no impact on the market. If they decide not to produce, market
prices don’t change.
Examples include roadside farmers markets.
This means that producers take the market price for their goods. They do not have enough power
to influence it.
Examples include tomato farmers and fishermen.
This means that anyone can easily engage in this activity. You
could become a fisherman tomorrow if you wanted. It
doesn’t mean you’ll succeed, but you can do it.
Market Structure Overview
Slide 2 of 19
This module: We’ll analyze perfectly competitive firms in the long run
Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly
PerfectCompetition
This is the topic of the
next module.
Then we’ll discuss all the firms in the middle in Module 11.
In this module, we’ll explore these firms in
the long run.
Slide 3 of 19
In the long run…things can change!
In the previous module, we learned how Joe, our perfectly competitive catfish farmer maximized his
profit in the short run.
Because he was a price taker, he took the price that the market gave him…that was $131 per unit in our
example.
Over time (in the long run) however, prices can change (as can many other things).
For example, what if a report came out stating that catfish was harmful to health? Price would fall.
Slide 4 of 19
Let’s look at two scenarios
In the first scenario, we’ll assume that catfish prices fall drastically…perhaps to $71 per unit.
We can use the MR=MC rule to determine Joe’s profit maximizing rate of output at that new price
and see what kind of profit Joe will earn.
We can then see if it is worthwhile for Joe to operate at this lower price. Perhaps he should
just go out of business.
We’ll call that analysis the “Shut Down Decision”.
MR=MC
Slide 5 of 19
Scenario #1: What if prices for catfish fell to $71?
Recall, Joe was selling catfish at $131 per bushel.
What if prices fell to $71. What is Joe’s profit maximizing output
PerfectCompetition
Slide 6 of 19
What if prices for catfish fell?Should Joe shut down?
Using MR>MC would dictate that Joe produce 5 units.
But if Joe produces his profit maximizing rate of output, which is 5 units, his profit is $-115.
It is cheaper to just shut down and lose the $100 in fixed costs!
Joe Should Shut Down!
PerfectCompetition
In the second scenario, well reduce catfish prices to $81 instead of $71 and repeat
the shut down decision analysis.
Joe definitely does not want to produce the 6th unit…it costs more (MC=$80) than it brings in (MR=$71).
Slide 7 of 19
Scenario 2: What if catfish prices fell instead to $81
Using MR>MC would dictate that Joe produce 6 units.
At that rate of output, profit is $-64.
That beats losing $100 in the short run! That is
called loss minimization!
What if prices fell to $81 instead of $71?
Joe Should not shut down in the short run!
PerfectCompetition
Slide 8 of 19
Do companies really operate in loss minimization?
Absolutely. They defer maintenance or other costs just trying to hang in there until things turn around.
Failure to upgradeUnsanitary Conditions
Willingness to let parts of facility
deteriorate
Just look for these signs:
PerfectCompetition
BSanitation
Grade
Slide 9 of 19
It is cheaper for Joe to shut down.
The shut down decision can be seen graphically, too
As long as price (which is MR) is above the AVC, the
perfectly competitive producer should stay open!
Note the new curve! To make a shut down
decision, we need to examine AVC also
Profit
We saw that at a price of $131, there is clearly profit for Joe to make!
LossLoss
At his profit maximizing rate of output (MR=MC at 9 units) MR is well above ATC and AVC!
We saw that at a price of $71,it is time for Joe
to shut down.
At the new profit maximizing rate of
output (MR=MC at 5 units) MR is below ATC
and AVC!
But at a price of $81, it was worthwhile for Joe
to stay open in the short run.
Note that MR>AVC!
At the new profit maximizing rate of
output (MR=MC at 6 units) MR is above
AVC, but below ATC.
At $81 per unit, Joe should not shut down in
the short run. He is engaged in loss minimization!
PerfectCompetition
Slide 10 of 19
0 Units
-$10Shutdown
No
Individual Exercise: Give the shut down decision a try!
Try filling out these blank cells and then answering the questions below..
PerfectCompetition
Slide 11 of 19
Perfect Competition from the industry perspective
So far, we have talked about an individual firm’s
perspective.
But remember that all firms collectively become
the supply side of the market.
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Slide 12 of 19
In perfect competition, there is a constant churn of firms entering and exiting the market
In cases where there are no profits to be made, firms go our of business.
In cases where there are profits being made, firms enter the industry to compete.
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Slide 13 of 19
Also recall that individual supply decisions collectively add up to the market supply
Each individual determines their own supply.
Those individual supply curves are added together to get a market supply curve
PerfectCompetition
Slide 14 of 19
Firm entry and exit affects the overall market
Imagine this represents a market where
perfectly competitive firms
are making profits.
As other business people see profits being
made in this industry, they
open a business and compete.
With more suppliers, the supply curve shifts right.
As more business people
enter the market, the
supply curve moves right even further.
PerfectCompetition
Slide 15 of 19
Where there are profits, firms enter and drive prices down
Imagine the graph on the left represents a perfectly competitive market and the graph on the right represents cost
and revenue curves for the typical firm in that industry.
Given that there are profits being made, new entrants in the market are lured in. They want to compete in this market to
earn some of the profits.
The entry of new business shifts the market supply curve right and drives prices down. However, there are still profits being
made, which will attract more entrants.
New firms will continue to enter this market until price reaches the lowest point on the Average Total Cost curve. With no profit to be made, no new firms enter and this industry is in
equilibrium.
PerfectCompetition
Market for Wheat Individual Wheat Producer
Slide 16 of 19
As consumers, we love perfect competition
We as consumers love perfect competition. It provides a mechanism that causes prices to find
the lowest point on the ATC.
In other words, we get these goods for as low a price as they can possibly be produced.
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Slide 17 of 19
A summary of perfect competition in the long run
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The existence of economic profits lures firms to enter.
The existence of economic losses induces firms to exit.
This churning process of firms constantly entering and exiting the market, like the tide of an ocean, is a characteristic of perfect competition
Slide 18 of 19
Churn in perfectly a competitive industry
Here’s a headline and excerpt from a recent article
Note the churning process and the constant drive to finds ways to produce at a lower price.
Keeping Dairy Cows on Pasture Lowers Cost of Milk
Small dairy farmers are going bankrupt by the thousands, largely due to declining milk prices. Keeping the cost of production low is one of the keys to staying solvent.
PerfectCompetition
Slide 19 of 19