© 2003 McGraw-Hill Ryerson Limited. Perfect Competition Chapter 11.

© 2003 McGraw-Hill Ryerson Limited.

Perfect CompetitionPerfect Competition

Chapter 11Chapter 11


11 - 2


The concept of competition is used in two ways in economics. Competition as a process is a rivalry

among firms. Competition as a market structure.


11 - 3

Competition as a Competition as a ProcessProcess Competition involves one firm trying to

take away market share from another firm.

As a process, competition pervades the economy.


11 - 4

A Perfectly Competitive A Perfectly Competitive MarketMarket A perfectly competitive market is one

which has highly restrictive assumptions, but which provides us with a reference point we can use in comparing different markets.


11 - 5

A Perfectly Competitive A Perfectly Competitive MarketMarket In a perfectly competitive market:

The number of firms is large. The firms' products are identical. There is free entry and exit, that is,

there are no barriers to entry. There is complete information. Firms are profit maximizers. Both buyers and sellers are price

takers.


11 - 6

The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition The number of firms is large.

Large number of firms means that any one firm's output is very small when compared with the total market.

What one firm does has no bearing on market quantity or market price.


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Firms' products are identical.

This requirement means that each firm's output is indistinguishable from any other firm’s output.

Firms sell homogeneous product.


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is free entry and free exit.

Firms are free to enter a market in response to market signals such as price and profit.

Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is free entry and free exit.

Technology may prevent some firms from entering the market.

There must also be free exit, without incurring a loss.


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is complete information.

Firms and consumers know all there is to know about the market – prices, products, and available technology.

Any technological advancement would be instantly known to all in the market.


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Firms are profit maximizers.

The goal of all firms in a perfectly competitive market is profit and only profit.

There is no non-price competition (based on quality, brand name, or the like).


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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Both buyers and sellers are price

takers. A price taker is a firm or individual

who takes the market price as given. Neither supplier nor buyer possesses

market power.


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Supply is a schedule of quantities of

goods that will be offered to the market at various prices.


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition This definition of supply requires the

supplier to be a price taker.


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Because of the definition of supply, if

any of the conditions required for perfect competition are not met, the formal definition of supply disappears.


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition That the number of suppliers be large

means that they do not have the ability to collude (act together with other firms to control price or market share).


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Other conditions make it impossible for

any firm to forget about the hundreds of other firms waiting to replace their supply.

A firm's goal is specified by the condition of profit maximization.


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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Even if the conditions for a perfectly

competitive market are not met, supply forces are still strong and many of the insights of the competitive model can be applied to firm behavior in other market structures.


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Demand Curves for the Demand Curves for the Firm and the IndustryFirm and the Industry The demand curve facing the firm is

different from the industry demand curve.

A perfectly competitive firm’s demand is horizontal (perfectly elastic), even though the demand curve for the industry is downward sloping.


11 - 20

Demand Curves for the Demand Curves for the Firm and the IndustryFirm and the Industry Each firm in a competitive industry is so

small that it does not need to lower its price in order to sell additional output.


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Market supply

Marketdemand

1,000 3,000

Price$10

8

6

4

2

0Quantity

Market Firm

Individual firm demand

Market Demand Curve Market Demand Curve Versus Individual Firm Versus Individual Firm Demand Curve, Demand Curve, Fig 11-1(a and b), p Fig 11-1(a and b), p 236236

10 20 30

Price$10

8

6

4

2

0Quantity

A B C


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The Profit-Maximizing The Profit-Maximizing Level of OutputLevel of Output The goal of the firm is to maximize

profits. When it decides what quantity to

produce it continually asks how changes in quantity would affect its profit.


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Profit-Maximizing Level Profit-Maximizing Level of Outputof Output Since profit is the difference between

total revenue and total cost, what happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC).

A firm maximizes profit when MC = MR.


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Profit-Maximizing Level Profit-Maximizing Level of Outputof Output Marginal revenue (MR) is the change

in total revenue associated with a change in quantity.

Marginal cost (MC) is the change in total cost associated with a one unit change in quantity.


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Marginal RevenueMarginal Revenue

Since a perfect competitor accepts the market price as given, for a perfectly competitive firm marginal revenue is equal to price (MR = P).


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Marginal CostMarginal Cost

Initially, marginal cost falls and then begins to rise.


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How to Maximize ProfitHow to Maximize Profit

To maximize profits, a firm should produce where marginal cost equals marginal revenue.


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If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.

The supplier will continue to produce as long as marginal cost is less than marginal revenue.


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The supplier will cut back on production if marginal cost is greater than marginal revenue.

Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.


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Marginal Cost, Marginal Marginal Cost, Marginal Revenue, and PriceRevenue, and Price Fig. 11- Fig. 11-

2a, p. 2372a, p. 237Price = MR Quantity Total Cost Marginal Cost

35 0 40 28

35 1 68 20

35 2 88 16

35 3 104 14

35 4 118 12

35 5 130 17

35 6 147 22

35 7 169 30

35 8 199 40

35 9 239 54

35 10 293


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BC

Area1

P = D = MR

Costs

1 2 3 4 5 6 7 8 9 10 Quantity

60

50

40

30

20

10

0

A

MC

Marginal Cost, Marginal Marginal Cost, Marginal Revenue, and Price,Revenue, and Price, Fig. 11- Fig. 11-

2b, p. 2372b, p. 237

Area 2


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The Marginal Cost The Marginal Cost Curve Is the Supply Curve Is the Supply CurveCurve The marginal cost curve, above the

point where price exceeds average variable cost, is the firm's supply curve


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The Marginal Cost The Marginal Cost Curve Is the Supply Curve Is the Supply CurveCurve The MC curve tells the competitive firm

how much it should produce at a given price.

The firm can do no better than producing the quantity at which marginal cost equals price which in turn equals marginal revenue.


11 - 34

The Marginal Cost Curve The Marginal Cost Curve Is the Firm’s Supply Is the Firm’s Supply Curve,Curve, Fig. 11-3, p. 239Fig. 11-3, p. 239

A

CMarginal cost$70

60

50

40

30

20

10

0 1 Quantity2 3 4 5 6 7 8 9 10

B

Cost, Price


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Firms Maximize Total Firms Maximize Total ProfitProfit Firms maximize total profit, not profit per

unit. As long as an increase in output yields

even a small amount of additional profit, a profit-maximizing firm will increase output.


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Profit Maximization Profit Maximization Using Total Revenue Using Total Revenue and Total Costand Total Cost Profit is maximized where the vertical

distance between total revenue and total cost is greatest.

At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.


11 - 37

TC TR

0

$385350315280245210175140105

7035

Quantity1 2 3 4 5 6 7 8 9

Profit Determination by Profit Determination by Total Cost and Revenue Total Cost and Revenue Curves, Curves, Fig. 11-4b, p 240Fig. 11-4b, p 240

Maximum profit =$81

$130

Loss

Loss

Profit

Total cost, revenue


11 - 38

Total Profit at the Total Profit at the Profit-Maximizing Level Profit-Maximizing Level of Outputof Output While the P = MR = MC condition tells

us how much output a competitive firm should produce to maximize profit, it does not tell us the profit the firm makes.


11 - 39

Determining Profit and Determining Profit and Loss From a Table of Loss From a Table of CostsCosts Profit can be calculated from a table of

costs and revenues. Profit is determined by total revenue

minus total cost.


11 - 40

Determining Profit and Determining Profit and Loss From a Table of Loss From a Table of CostsCosts The profit-maximizing output choice is

not necessarily a position that minimizes either average variable cost or average total cost.

It is only the choice that maximizes total profit.


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Costs Relevant to a Firm, Costs Relevant to a Firm, Table 11-1, p 241Table 11-1, p 241


11 - 42

Costs Relevant to a Firm, Costs Relevant to a Firm, Table 11-1, p 241Table 11-1, p 241


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Determining Profit and Determining Profit and Loss From a GraphLoss From a Graph Find output where MC = MR. The intersection of MC = MR (P)

determines the quantity the firm will produce if it wishes to maximize profits.


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Determining Profit and Determining Profit and Loss From a GraphLoss From a Graph Find profit per unit where MC = MR. To determine maximum profit, you must

first determine what output the firm will choose to produce.

See where MC equals MR, and then draw a line down to the ATC curve.

This is the profit per unit.

(a) Positive economic profit (b) Zero economic profit (c) Economic loss

Determining Profits Determining Profits Graphically,Graphically, Fig. 11-5, p 243 Fig. 11-5, p 243

Quantity Quantity Quantity

Price65 60 55 50 45 40 35 30 25 20 15 10

5 0

65 60 55 50 45 40 35 30 25 20 15 10

5 01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12

D

MC

A P = MR

B ATCAVC

E

Profit

C

MC

ATC

AVC

MC

ATC

AVC

Loss

65 60 55 50 45 40 35 30 25 20 15 10

5 0 1 2 3 4 5 6 7 8 910 12

P = MRP = MR

Price Price

© The McGraw-Hill Companies, Inc., 2000


11 - 46

Zero Profit or Loss Zero Profit or Loss Where MC=MRWhere MC=MR Firms can also earn zero profit or even

a loss where MC = MR. Even though economic profit is zero, all

resources, including entrepreneurs, are being paid their opportunity costs.


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Zero Profit or Loss Zero Profit or Loss Where MC=MRWhere MC=MR In all three cases (profit, loss, zero

profit), determining the profit-maximizing output level does not depend on fixed cost or average total cost, but only where marginal cost equals price.


11 - 48

The Role of Profits as The Role of Profits as Market Signals,Market Signals, Table 11-2, p 243 Table 11-2, p 243

Profit Calculation

Type of Profit Market Signal

> 0 Positive economic profit, or

Economic profit

Entry. Resources are drawn into the industry.

= 0 Zero economic profit,

Zero profit, or

Normal profit

Static. The industry is in long run equilibrium.

< 0 Economic loss Exit. Resources leave the industry.


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The Shutdown PointThe Shutdown Point

The firm will shut down if it cannot cover variable costs. A firm should continue to produce as

long as price is greater than average variable cost.

Once price falls below that point it will be cheaper to shut down temporarily and save the variable costs.


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The shutdown point is the point at which the firm will be better off by shutting down than it will if it stays in business.


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As long as total revenue is more than total variable cost, temporarily producing at a loss is the firm’s best strategy since it is taking less of a loss than it would by shutting down (loss minimization).


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MC

P = MR

2 4 6 8 Quantity

Price

60

50

40

30

20

10

0

ATC

AVC

Loss

A$17.80

The Shutdown The Shutdown Decision, Decision, Fig.11-6a, p 245Fig.11-6a, p 245


11 - 53

Long-Run Competitive Long-Run Competitive Equilibrium, Equilibrium, Fig.11-6b, p 245Fig.11-6b, p 245

MC

P = MR

0

60

50

40

30

20

10

Price

2 4 6 8 Quantity

SRATC LRATC


11 - 54

Short-Run Market Short-Run Market Supply and DemandSupply and Demand While the firm's demand curve is

perfectly elastic, the industry demand is downward sloping.

Industry supply is the sum of all firms’ supply curves.


11 - 55

Short-Run Market Short-Run Market Supply and DemandSupply and Demand In the short run when the number of

firms in the market is fixed, the market supply curve is just the horizontal sum of all the firms' marginal cost curves.


11 - 56

Short-Run Market Short-Run Market Supply and DemandSupply and Demand Since all firms have identical marginal

cost curves, a quick way of summing the quantities is to multiply the quantities from the marginal cost curve of a representative firm by the number of firms in the market.


11 - 57

The market supplyThe market supply In the long run, the number of firms may

change in response to market signals, such as price and profit.

As firms enter the market in response to economic profits being made, the market supply shifts to the right.

As economic losses force some firms to exit, the market supply shifts to the left.


11 - 58

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Profits and losses are inconsistent with

long-run equilibrium. Profits create incentives for new firms to

enter, output will increase, and the price will fall until zero economic profits are made.

Only zero economic profit will stop entry.


11 - 59

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium The existence of losses will cause some

firms to leave the industry. In a long run equilibrium firms make no

economic profit (the zero profit condition).


11 - 60

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Zero profit does not mean that the

entrepreneur does not get anything for his efforts.


11 - 61

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium In order to stay in business the

entrepreneur must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative).


11 - 62

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Normal profits are included as a cost.

Economic profits are profits above normal profits.


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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Even if some firm has super efficient

workers or machines that produce rent, it will not take long for competitors to match these efficiencies and drive down the price, until all economic profits are eliminated.


11 - 64

Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium The zero profit condition is enormously

powerful. As long as there is free entry and exit,

price will be pushed down to the average total cost of production.


11 - 65

Adjustment from the Adjustment from the Short Run to the Long Short Run to the Long RunRun Industry supply and demand curves

come together to lead to long-run equilibrium.


11 - 66

An Increase in DemandAn Increase in Demand

An increase in demand leads to higher prices and higher profits.

Existing firms increase output and new firms will enter the market, increasing industry output still more, price will fall until all profit is competed away.


11 - 67


If the the market is a constant-cost industry, the new equilibrium will be at the original price but with a higher market output.

A market is a constant-cost industry if the long-run industry supply curve is perfectly elastic (horizontal).


11 - 68


The original firms return to their original output but since there are more firms in the market, the total market output increases.


11 - 69


In the short run, the price does more of the adjusting.

In the long run, more of the adjustment is done by quantity.


11 - 70

Profit$9

10120

FirmPrice

Quantity

B

A

Market Response to an Market Response to an Increase in Demand,Increase in Demand,Fig. 11-Fig. 11-

7, p 2487, p 248

Market

Quantity

Price

0

B

A

C

MC

AC

SLR

S0SR

D0

7

700

$9

8401,200

D1

S1SR

7


11 - 71

Long-Run Market Long-Run Market SupplySupply Two other possibilities exist:

Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity.

Decreasing-cost industry – factor prices fall as industry output expands.


11 - 72

An Increasing-Cost An Increasing-Cost IndustryIndustry If inputs are specialized, factor prices

are likely to rise when the increase in the industry-wide demand for inputs to production increases.


11 - 73

An Increasing-Cost An Increasing-Cost IndustryIndustry This rise in factor costs would raise

costs for each firm in the industry and increase the price at which firms earn zero profit (break even).


11 - 74

An Increasing-Cost An Increasing-Cost IndustryIndustry Therefore, in increasing-cost industries,

the long-run supply curve is upward sloping.


11 - 75

A Decreasing-Cost A Decreasing-Cost IndustryIndustry If input prices decline when industry

output expands, individual firms' cost curves shift down.

The price at which firms break even now decreases, and the long-run market supply curve is downward sloping.


11 - 76

An Example: Canadian An Example: Canadian Retail IndustryRetail Industry During the 1990s the Canadian retail

industry illustrated how a competitive market adjusts to changing market conditions.


11 - 77

An Example: Canadian An Example: Canadian Retail IndustryRetail Industry Many retailers were lost or absorbed by

competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others.

Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy.


11 - 78

An Example: Canadian An Example: Canadian Retail IndustryRetail Industry As prices fell, P=MR fell below their

ATC. But since price remained above the

AVC, many firms closed their less profitable locations and continued to operate.


11 - 79

An Example: Canadian An Example: Canadian Retail IndustryRetail Industry When demand did not recover, firms ran

out of options. Many firms realized as they moved into

the long run that they have to exit the Canadian retail industry.


11 - 80

Price

Quantity

MC

ATC

AVC

P = MR

Loss

An Example: A An Example: A Shutdown Decision, Shutdown Decision, Fig. 11-Fig. 11-

8, p 2508, p 250



End of Chapter 11End of Chapter 11

© 2003 McGraw-Hill Ryerson Limited. Perfect Competition Chapter 11.

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Transcript of © 2003 McGraw-Hill Ryerson Limited. Perfect Competition Chapter 11.