2.1. Perfect Competition

PERFECT COMPETITION

Objectives After studying this chapter, you will able to  Define perfect competition  Explain how price and output are determined in perfect competition  Explain why firms sometimes shut down temporarily and lay off workers  Explain why firms enter and leave the industry  Predict the effects of a change in demand and of a technological advance  Explain why perfect competition is efficient

Sweet Competition Maple syrup is produced by 12,000 farms in the United States and Canada in a highly competitive market. We study such a market in this chapter. We explain the changes in price and output as the firms in perfect competition respond to changes in demand and technological change.

Competition Perfect competition is an industry in which:  Many firms sell identical products to many buyers.  There are no restrictions to entry into the industry.  Established firms have no advantages over new ones.  Sellers and buyers are well-informed about prices.

Competition How Perfect Competition Arises Perfect competition arises:  When a firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry  And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from

Competition Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the price of a good or service. No single firm can influence the price—it must “take” the equilibrium market price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

Competition Economic Profit and Revenue The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P × Q.

Competition A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Figure 11.1 illustrates a firm’s revenue curves.

Competition Figure 11.1(a) shows that market demand and supply determine the price that the firm must take.

Competition Figure 11.1(b) shows the demand curve for the firm’s product, which is also its marginal revenue curve.

Competition Because in perfect competition the price remains the same as the quantity sold changes, marginal revenue equals price.

Competition

Figure 11.1(c) shows the firm’s total revenue curve.

The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints:  A market constraint summarized by the market price and the firm’s revenue curves  A technology constraint summarized by the firm’s product curves and cost curves

The Firm’s Decisions in Perfect Competition The perfectly competitive firm makes two decisions in the short run:  Whether to produce or to shut down.  If the decision is to produce, what quantity to produce. A firm’s long-run decisions are:  Whether to increase or decrease its plant size.  Whether to stay in the industry or leave it.

The Firm’s Decisions in Perfect Competition Profit-Maximizing Output A perfectly competitive firm chooses the output that maximizes its economic profit. One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves. Figure 11.2 on the next slide looks at these curves along with the firm’s total profit curve.

The Firm’s Decisions in Perfect Competition Part (a) shows the total revenue, TR, curve. Part (a) also shows the total cost curve, TC, Total revenue minus total cost is profit (or loss), shown in part (b).

The Firm’s Decisions in Perfect Competition Profit is maximized when the firm produces 9 sweaters a day. At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

The Firm’s Decisions in Perfect Competition At intermediate output levels, the firm earns an economic profit. At high output levels, the firm again incurs an economic loss—now it faces steeply rising costs because of diminishing returns.

The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profitmaximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. Figure 11.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.

The Firm’s Decisions in Perfect Competition If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

The Firm’s Decisions in Perfect Competition Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit-maximizing output with the market price. Figure 11.4 on the next slide shows the three possible profit outcomes.

The Firm’s Decisions in Perfect Competition In part (a) price equals ATC and the firm earns zero economic profit (normal profit).

The Firm’s Decisions in Perfect Competition In part (b), price exceeds ATC and the firm earns a positive economic profit.

The Firm’s Decisions in Perfect Competition In part (c) price is less than ATC and the firm incurs an economic loss—economic profit is negative and the firm does not even earn normal profit.

The Firm’s Decisions in Perfect Competition The Firm’s Short-Run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily.

The Firm’s Decisions in Perfect Competition Temporary Plant Shutdown If the price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at a price below average variable cost, it would incur an additional (and avoidable) loss.

The Firm’s Decisions in Perfect Competition The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action.

The Firm’s Decisions in Perfect Competition If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost.

The Firm’s Decisions in Perfect Competition Figure 11.5 shows how the firm’s short-run supply curve is constructed. If price equals minimum average variable cost, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

The Firm’s Decisions in Perfect Competition If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC. If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve.

The Firm’s Decisions in Perfect Competition Short-Run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

The Firm’s Decisions in Perfect Competition The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price.

The Firm’s Decisions in Perfect Competition At a price equal to minimum average variable cost—the shutdown price —the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produce zero.

Output, Price, and Profit in Perfect Competition Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. Figure 11.7 shows a shortrun equilibrium at the intersection of the demand and supply curves.

Output, Price, and Profit in Perfect Competition A Change in Demand An increase in demand brings a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand brings a leftward shift of the industry demand curve: the price falls and the quantity decreases.

Output, Price, and Profit in Perfect Competition Long-Run Adjustments In short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur an economic loss. Which of these states exists determines the further decisions the firm makes in the long run. In the long run, the firm may:  Enter or exit an industry  Change its plant size

Output, Price, and Profit in Perfect Competition Entry and Exit New firms enter an industry in which existing firms earn an economic profit. Firms exit an industry in which they incur an economic loss. Figure 11.8 on the next slide shows the effects of entry and exit.

Output, Price, and Profit in Perfect Competition As new firms enter an industry, industry supply increases. The industry supply curve shifts rightward. The price falls, the quantity increases, and the economic profit of each firm decreases.

Output, Price, and Profit in Perfect Competition As firms exit an industry, industry supply decreases. The industry supply curve shifts leftward. The price rises, the quantity decreases, and the economic profit of each firm increases.

Output, Price, and Profit in Perfect Competition Changes in Plant Size Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. Figure 11.9 on the next slide shows the effects of changes in plant size.

Output, Price, and Profit in Perfect Competition If the price is $25, firms earn zero economic profit with the current plant.

Output, Price, and Profit in Perfect Competition But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant.

Output, Price, and Profit in Perfect Competition As the plant size increases, short-run supply increases, the price falls, and economic profit decreases.

Output, Price, and Profit in Perfect Competition Long-run equilibrium occurs when the firm is producing at the minimum long-run average cost and earning zero economic profit.

Output, Price, and Profit in Perfect Competition Long-Run Equilibrium Long-run equilibrium occurs in a competitive industry when:  Economic profit is zero, so firms neither enter nor exit the industry.  Long-run average cost is at its minimum, so firms don’t change their plant size.

Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases.

Changing Tastes and Advancing Technology Starting from a position of long-run equilibrium, the fall in price puts the price below each firm’s minimum average total cost and firms incur an economic loss.

Changing Tastes and Advancing Technology Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward.

Changing Tastes and Advancing Technology As industry supply decreases, the price rises and the market quantity continues to decrease.

Changing Tastes and Advancing Technology With a rising price, each firm that remains in the industry increases production in a movement along the firm’s marginal cost curve (short-run supply curve).

Changing Tastes and Advancing Technology A new long-run equilibrium occurs when the price has risen to equal minimum average total cost so that firms do not incur economic losses, and firms no longer leave the industry.

Changing Tastes and Advancing Technology The main difference between the initial and new long-run equilibrium is the number of firms in the industry.

Changing Tastes and Advancing Technology In the new equilibrium, a smaller number of firms produce the equilibrium quantity.

Changing Tastes and Advancing Technology A permanent increase in demand has the opposite effects to those just described and shown in Figure 11.9. An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward. As industry supply increases, the price falls and the market quantity continues to increase.

Changing Tastes and Advancing Technology With a falling price, each firm decreases production in a movement along the firm’s marginal cost curve (short-run supply curve). A new long-run equilibrium occurs when the price has fallen to equal minimum average total cost so that firms do not earn economic profits, and firms no longer enter the industry. The main difference between the initial and new long-run equilibrium is the number of firms in the industry. In the new equilibrium, a larger number of firms produce the equilibrium quantity.

Changing Tastes and Advancing Technology External Economies and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases.

Changing Tastes and Advancing Technology In the absence of external economies or external diseconomies, a firm’s costs remain constant as industry output changes. Figure 11.11 illustrates the three possible cases and shows the long-run industry supply curve, which shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made, including changes in plant size and the number of firms in the industry.

Changing Tastes and Advancing Technology

Figure 11.11(a) shows that in the absence of external economies or external diseconomies, the price remains constant when demand increases.

Changing Tastes and Advancing Technology

Figure 11.11(b) shows that when external diseconomies are present, the price rises when demand increases.

Changing Tastes and Advancing Technology

Figure 11.11(c) shows that when external economies are present, the price falls when demand increases.

Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to produce at a lower average cost and lower marginal cost—firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit.

Changing Tastes and Advancing Technology New-technology firms enter and old-technology firms either exit or adopt the new technology. Industry supply increases and the industry supply curve shifts rightward. The price falls and the quantity increases. Eventually, a new long-run equilibrium emerges in which all the firms use the new technology, the price has fallen to the minimum average total cost, and each firm earns normal profit.

Changing Tastes and Advancing Technology The adjustment process as old-technology firms exit or adopt the new technology and new-technology firms enter can create great changes in local geographic prosperity. Some regions experience economic decline while others experience economic growth.

Competition and Efficiency Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. This situation arises when marginal benefit equals marginal cost.

Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. We derive a consumer’s demand curve by finding how the best (most valued by the consumer) budget allocation changes as the price of a good changes. So consumers get the most value out of their resources at all points along their demand curves, which are also their marginal benefit curves.

Competition and Efficiency We derive a competitive firm’s supply curve by finding how the profit-maximizing quantity changes as the price of a good changes. So firms get the most value out of their resources at all points along their supply curves, which are also their marginal cost curves. In competitive equilibrium, the quantity demanded equals the quantity supplied, so marginal benefit equals marginal cost. All gains from trade have been realized.

Competition and Efficiency Figure 11.12 illustrates an efficient outcome in a perfectly competitive industry. Along the demand curve D = MB the consumer is efficient. Along the supply curve S = MC the producer is efficient.

Competition and Efficiency If the quantity produced were Q0, marginal benefit B0 would exceed marginal cost C0 and everyone would be better off if production increased. If the quantity produced were Q*, marginal benefit would equal marginal cost at P*. This outcome is efficient.

Competition and Efficiency The quantity Q* and price P* are the competitive equilibrium values. So competitive equilibrium is efficient. The consumer gains the consumer surplus, and the producer gains the producer surplus.

Competition and Efficiency Competitive equilibrium is efficient only if there are no external benefits or costs. External benefits are benefits that accrue to people other than the buyer of a good. External costs are costs that are borne not by the producer of a good or service but by someone else.

Competition and Efficiency Efficiency of Perfect Competition Three main obstacles to achieving efficiency in resource allocation are:  Monopoly  Public goods  External costs and benefits

Competition and Efficiency Monopoly restricts output to increase price and profit. Public goods are goods from which everyone benefits but no one would willingly pay, so a competitive market would produce a quantity below the efficient level. External costs or benefits mean that demand curves do not measure all the benefits and cost curves do not measure all the costs, so the competitive market might produce too much or too little.

PERFECT COMPETITION

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