Ch 08 perfect competition micro econ4

Chapter 2 ECON4 William A. McEachern

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Perfect

Competition

2

Introduction to Perfect Competition

• Market structure

– Number of suppliers

– Product’s degree of uniformity

– Ease of entry into the market

– Forms of competition among forms

• A firm’s decisions

– How much to produce; what price to

charge

– Depend on the structure of the market© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Perfectly Competitive Market

• Perfect competition

– Many buyers and sellers

– Commodity; standardized product

– Fully informed buyers and sellers

– No barriers to entry

• Individual buyer or seller

– No control over price

– Price takers



Demand under Perfect Competition

• Market price

– Determined by supply and demand

• Demand curve facing one supplier

– Horizontal line at the market price

– Perfectly elastic



Demand under Perfect Competition

• Price taker

– Firm that faces a given market price

• Its quantity supplied has no effect on that

price

– Perfectly competitive firm that decides to

produce

• Must accept, or “take,” the market price



Exhibit 1

6

Market equilibrium & firm’s demand curve in perfect competitionP

rice p

er

bushel

$5

D

S

(a) Market equilibrium

Price p

er

bushel

$5 d

(b) Firm’s demand

1,200,000 Bushels of

wheat per day

0 15 Bushels of

wheat per day

0 5 10

In panel (a), the market price of $5 is determined by the intersection of the market

demand and market supply curves. A perfectly competitive firm can sell any amount

at that price. The demand curve facing the perfectly competitive firm is horizontal at

the market price, as shown by demand curve d in panel (b).

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Short Run Profit Maximization

• Maximize economic profit

– Quantity at which total revenue exceeds

total cost by the greatest amount

• Total revenue, TR

• Total cost, TC

• Profit = TR – TC

• If TR > TC: economic profit

• If TC > TR: economic loss




• Marginal revenue, MR

• Average revenue, AR

– Total revenue divided by quantity

• MR = P = AR

– Along a perfectly competitive firm’s

demand curve

• Marginal cost, MC




• Maximize economic profit:

– Increase production as long as each

additional unit adds more to TR than TC

• Golden rule

– Expand output: MR>MC

– Stop before MC>MR



Exhibit 2

10

Maximizing Short-Run Profit for a Perfectly Competitive Firm



Exhibit 3

11

Short-run profit maximization for a perfectly competitive firm

Total cost Total revenue

(=$5 × q)

Tota

l dolla

rs $60

48

15

Bushels of wheat per day0 5 7 10 12 15

Do

llars

pe

r b

ush

el

$5

4

Bushels of wheat per day0 5 7 10 12 15

(a) Total revenue minus total cost

(b) Marginal cost equals marginal revenue

Average total cost

d = Marginal revenue

= Average revenue

Marginal cost

Maximum economic

profit = $12

In panel (a), the total revenue curve for

a perfectly competitive firm is a straight

line with a slope of 5, the market price.

Total cost increases with output, first at a

decreasing rate and then at an

increasing rate. Economic profit is

maximized where total revenue exceeds

total cost by the greatest amount, which

occurs at 12 bushels of wheat per day.

a

e

Profit

In panel (b), marginal revenue is a

horizontal line at the market price

of $5. Economic profit is

maximized at 12 bushels of wheat

per day, where marginal revenue

equals marginal cost (point e).

That profit equals 12 bushels

multiplied by the amount by which

the market price of $5 exceeds the

average total cost of $4. Economic

profit is identified by the shaded

rectangle.



Minimizing Short-Run Losses

• Total cost, TC = FC+VC

• Shut down in short run: pay fixed cost

• If TC<TR: economic loss

– Produce if TR>VC (P>AVC)

• Revenue covers variable costs and a portion

of fixed cost

• Loss < fixed cost

– Shut down (short run) if TR<VC (P<AVC)

• Loss = FC



Exhibit 4

13

Minimizing Short-Run Losses for a Perfectly Competitive Firm



Exhibit 5

14

Short-Run Loss Minimization for a Perfectly Competitive Firm

Total cost Total revenue

(=$3 × q)

Tota

l dolla

rs

$40

30

15

Bushels of wheat per day0 5 10 15

(a) Total revenue minus total cost

(b) Marginal cost equals marginal revenue

Average total cost

d = Marginal revenue

= Average revenue

Marginal cost

Minimum economic

loss = $10

Because total cost always

exceeds total revenue in

panel (a), the firm suffers a

loss no matter how much is

produced. The loss is

minimized where output is

10 bushels per day. Panel

(b) shows that marginal

revenue equals marginal

cost at point e. The loss is

equal to output of 10

multiplied by the difference

between average total cost

($4) and price ($3).

Because price exceeds

average variable cost

($2.50), the firm is better off

continuing to produce in the

short run, since revenue

covers some fixed cost.

eLoss

Bushels of wheat per day0 5 10 15

Dolla

rs p

er

bushel

$4.00

3.00

2.50

Average variable cost



Firm & Industry Short-Run S Curves

• Short-run firm supply curve

– How much firms supply in the short run

– Upward sloping portion of firm’s MC curve

– Above minimum AVC curve

• Short-run industry supply curve

– Quantity supplied by industry at each

price in the short run

– Horizontal sum of all firms’ short-run

supply curves



Exhibit 6

16

Summary of a perfectly competitive firm’s short-run output decisions

Average total cost

Average variable cost

Marginal cost

d1

d2

d3

d4

d5

1

2

3

4

5

q2 q3 q4 q5q1 Quantity per period

p2

p1

p3

p4

p5

0

Dolla

rs p

er

unit

Shutdown

point

Break-even

point

At p4, the firm produces q4 and just breaks even, earning a normal profit, because p4 equals

average total cost. Finally, at p5, the firm produces q5 and earns an economic profit. The firm’s

short-run supply curve is that portion of its marginal cost curve at or rising above the minimum

point of average variable cost (point 2).

Firm’s short run S curve

At price p1, the firm produces

nothing because p1 is less

than the firm’s average

variable cost. At price p2, the

firm is indifferent between

shutting down or producing

q2 units of output, because in

either case, the firm suffers a

loss equal to its fixed cost. At

p3, it produces q3 units and

suffers a loss that is less

than its fixed cost.



Exhibit 7

17

Aggregating individual supply curves of perfectly competitive

firms to form the market supply curve

10 20

Quantity per period

0

p

p’

Price p

er

unit sA

(a) Firm A

10 200

p

p’

sB

(b) Firm B

10 20

Quantity per period

0

p

p’

sC

(c) Firm C

30 60

Quantity per period

0

p

p’

sA + sB + sC = S

(d) Industry, or market, supply

At price p, each firm supplies 10 units of output & market supplies 30 units. In general, the market

supply curve in panel (d) is the horizontal sum of the individual firm supply curves sA, sB, and sC.



Firm Supply & Market Equilibrium

• Short run, perfect competition

– Market converges to equilibrium P and Q

– Firm

• Max profit

• Min loss

• Shuts down temporarily



Exhibit 8

19

Short-Run Profit Maximization and Market Equilibrium in

Perfect Competition(a) Firm

d

(b) Industry, or market

1,200,000Bushels of

wheat per day012

Bushels of

wheat per day0 5 10

MC = s

ATC

AVC

Dolla

rs p

er

unit

$5

4 Price p

er

unit

$5Profit

∑ MC = S

D

The market supply curve S in panel (b) is the horizontal sum of the supply curves of all 100,000

firms in this perfectly competitive industry. The intersection of S with the market demand curve D

determines the market price of $5. That price, in turn, determines the height of the perfectly elastic

demand curve facing the individual firm in panel (a). That firm produces 12 bushels per day

(where marginal cost equals marginal revenue of $5) and earns economic profit in the short run of

$1 per bushel, or $12 in total per day.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Perfect Competition in Long Run

• Long run

– Firms enter/exit the market

– Firms adjust scale of operations

• Until average cost is minimized

– All resources are variable




• Economic profit in short run

– New firms enter the market in long run

– Existing firms expand in long run

– Market supply increases

• Price decreases

• Economic profit disappears

• Firms break even




• Economic loss in short run

– Some firms exit the market in long run

– Some firms reduce scale in long run

– Market supply decreases

• Price increases

• Economic loss disappears

• Firms break even



Zero Economic Profit in Long Run

• Firms enter, leave, change scale

• Market:

– S shifts; P changes

• Firm

– d(P=MR=AR) shifts

– Long run equilibrium

• MR=MC =ATC=LRAC

• Normal profit

• Zero economic profit



Exhibit 9

24

Long-run equilibrium for a firm & industry in perfect competition

(a) Firm

d


QQuantity

per period0q

Quantity

per period0

MC

ATC

Dolla

rs p

er

unit

p

Price p

er

unit

p

S

D

LRAC

In long-run equilibrium, the firm produces q units of output per period and earns a normal

profit. At point e, price, marginal cost, marginal revenue, short-run average total cost, and

long-run average cost are all equal. There is no reason for new firms to enter the market

or for existing firms to leave. As long as the market demand and supply curves remain

unchanged, the industry will continue to produce a total of Q units of output at price p.

e



Long-Run Adjustment

• Effects of an Increase in Demand

– Short run

• P increases; d increases

• Firms increase quantity supplied

• Economic profit

– Long run

• New firms enter the market

• S increases, P decreases

• Firm’s d curve decreases

• Normal profit25© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Exhibit 10

26

Long-run Adjustment in Perfect Competition to an Increase

in Demand(a) Firm

d


MC

ATC

S

D

LRAC

D’

a

b

Price p

er

unit

p

p’

Qa

Quantity

per period0 Qb Qc

Dolla

rs p

er

unit

p

p’ d’

qQuantity

per period0 q’

Profit

An increase in market demand from D to D’ in panel (b) moves the short-run market equilibrium point

from a to b. Output increases to Qb, and price rises to p. The price rise shifts up the individual firm’s

demand curve from d to d’ in panel (a). The firm responds to the higher price by increasing output to q

and earns economic profit identified by the shaded rectangle. Economic profit attracts new firms to the

industry in the long run. Market supply shifts right to S’ in panel (b), pushing the market price back down

to p. In panel (a), the firm’s demand curve shifts back down to d, erasing economic profit. The short-run

adjustment is from point a to point b in panel (b), but the long-run adjustment is from point a to point c.

S’

c S*



Long-Run Adjustment

• Effects of a Decrease in Demand

– Short run

• P decreases; d decreases

• Firms decrease quantity supplied

• Economic loss

– Long run

• Firms exit the market

• S decreases, P increases

• Firm’s d curve increases

• Normal profit27© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Exhibit 11

28

Long-Run Adjustment in Perfect Competition to a Decrease

in Demand(a) Firm

d


MC

ATC

SD

LRAC

D’’

a

f

Price p

er

unit

p

p’’

Qg

Quantity

per period0 Qf Qa

Dolla

rs p

er

unit

p

p’’ d’’

qQuantity

per period0 q’’

Loss

A decrease of demand to D” in panel (b) disturbs the long-run equilibrium at point a. The price

drops to p” in the short run; output falls to Qf. In panel (a), the firm’s demand curve shifts down

to d. Each firm cuts output to q” and suffers a loss. As firms leave the industry in the long run,

the market supply curve shifts left to S”. Market price rises to p as output falls further to Qg. At

price p, the remaining firms once again earn a normal profit. Thus, the short-run adjustment is

from point a to point f in panel (b); the long-run adjustment is from point a to point g.

S’’

gS*



Long-Run Industry Supply Curve

• Short run

– Change quantity supplied along MC curve

• Long run industry supply curve, S*

– After firms fully adjust

• Constant-cost industries

– LRAC doesn’t shift with output

– Long run S* curve for industry: straight

horizontal line



Increasing Cost Industries

– Average costs increase as output expands

• Effects of an increase in demand

– Short run

• P increases; d increases

• Firms increase q; Economic profit

– Long run

• New firms enter the market;

• Market: S increases; P decreases

• Firm: MC and ATC increase; d curve

decreases; Zero economic profit30© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Exhibit 12

31

Long-Run Adjustment for an Increasing-Cost Industry

(a) Firm

da

(b) Industry, or marketMC

ATC

S

D

D’

a

b

Qa

Quantity per

period0 Qb Qc

db

qQuantity per

period0 qb

S’

c

Pri

ce p

er

unit

pa

pb

pc

Do

llars

pe

r un

it

pa

pb

pc

S*

dc

a

b ATC’

MC’

c

An increase in demand to D’ in panel (b) disturbs the initial equilibrium at point a. Short-run equilibrium is at

point b, where D’ intersects the short-run market supply curve S. At the higher price pb, the firm’s demand

curve shifts up to db, and its output increases to qb in panel (a). At point b, the firm is now earning economic

profit, which attracts new firms. As new firms enter, input prices get bid up, so each firm’s marginal and

average cost curves rise. New firms increase the short-run market supply curve from S to S’. The intersection

of the new market supply curve, S’, with D’ determines the market price, pc. At pc, individual firms are earning

a normal profit. Point c shows the long-run equilibrium. By connecting long-run equilibrium points a and c in

panel (b), we obtain the upward-sloping long-run market supply curve S* for this increasing-cost industry.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Perfect Competition & Efficiency

• Productive efficiency: Making Stuff Right

– Produce output at the least possible cost

• Min point on LRAC curve

• P = min average cost in long run

• Allocative efficiency: Making the Right

Stuff

– Produce output that consumers value most

• Marginal benefit = P = Marginal cost

• Allocative efficient market



Perfect Competition

• Consumer surplus

– Consumers pay less (P)

– Than they are willing to pay (along D

curve)

• Producer surplus

– Producers are willing to accept less

(along S curve; MC)

– Than what they are receiving (P)



Perfect Competition

• Gains from voluntary exchange

– Consumer and producer surplus

– Productive and allocative efficiency

– Maximum social welfare

• Social welfare

– Overall well-being of people in the

economy

– Maximized when: marginal cost of

production = marginal benefit to consumers



Exhibit 13

35

Consumer Surplus and Producer Surplus for Perfectly

Competitive Market

0 100,000120,000

200,000Quantity

per period

$10

6

5

Dolla

rs p

er

unit

S

D

e

m

Consumer

surplus

Producer

surplus

Consumer surplus is represented by

the area above the market-clearing

price of $10 per unit and below the

demand curve; it appears as the blue

triangle. Producer surplus is

represented by the area above the

short-run market supply curve and

below the market-clearing price of

$10 per unit; it appears as the gold

area. At a price of $5 per unit, there

would be no producer surplus. At a

price of $6 per unit, producer surplus

would be the gold shaded area

between $5 and $6. A price of $5 just

covers each firm’s average variable

cost.



Economy & Finance

Ch 08 perfect competition micro econ4