Chapter 8

Perfect Competition

© 2009 South-Western/ Cengage Learning

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An Introduction to Perfect Competition

• Firm’s goal: maximize profit

• Market structure– # and size of firms

– nature of product

– entry/exit possibilities in market

– forms of competition among firms

Perfectly Competitive Market Structure

• many, small buyers and sellers• homogenous product• no barriers to entry/exit• perfect information• mobile resources• no public goods / externalities

• “price-taking behavior”3

Demand Under Perfect Competition

• Market price– determined in market by interaction

between S and D

• Demand curve facing one firm– horizontal line at the market price

– perfectly elastic

• Law of Demand applies to market demand, not the firm’s perceived demand

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Short Run Profit Maximization

• Maximize economic profit– Quantity at which TR exceeds TC by the

greatest amount

• Total revenue = TR• Total cost = TC• Profit = TR – TC• If TR > TC: economic profit• If TC > TR: economic loss

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Short Run Profit Maximization

• Marginal analysis• Marginal revenue: MR

– MR is the change in total revenue when a firm sells 1 additional unit

– MR = ∆TR / ∆q

• Marginal cost: MC – MC = ∆TC / ∆q

• (previously defined)

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Short Run Profit Maximization

• Maximize economic profit:– Increase production as long as each

additional unit increases profit• The increase in TR must exceed the

increase in TC for the next unit

• Golden rule – Expand output whenever MR>MC

– Stop before MR<MCThis is true for all firms in all market structures

In Perfect Competition: MR = P 7

Minimizing Short-Run Losses

• TC = FC+VC• in short run a firm must pay fixed cost

even if q = 0• If TC<TR there is an economic loss

– Produce if TR>VC (P>AVC)• Revenue covers variable costs and a portion

of fixed cost• Loss < fixed cost

– Shut down if TR<VC (P<AVC)• Loss = FC 8

Maximizing Profit in Short Run

• Choose q such that– MR = MC

• Gives us the output level

• Profit > 0 if P > AC• We have our optimal level of q

• Profit = 0 if P = AC• We have our optimal level of q

• Profit < 0 if P < AC–If P > AVC we have our optimal level of q–If P < AVC shutdown (q = 0) 9

Firm and Industry Short-Run S curves

• Supply shows the quantities that firm’s will produce at various prices

• Short-run firm supply curve– Upward sloping portion of MC curve

– Above minimum AVC curve

• Short-run industry supply curve– Horizontal sum of all firms’ short-run

supply curves

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Exhibit 7Aggregating individual supply to form market supply

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10 20Quantity

per period

0

p

p’

Pric

e pe

r un

it SA

(a) Firm A

10 20Quantity

per period

0

p

p’

SB

(b) Firm B

10 20Quantity

per period

0

p

p’

SC

(c) Firm C

30 60Quantity per period

0

p

p’

SA + SB + SC = S

(d) Industry, or market, supply

Firm Supply and Market Equilibrium

• Perfect competition in the short run – Market level

• converges to equilibrium P and Q

– Firm level• Max profit• Min loss• Shuts down temporarily

• All firms in industry are producing where P = MC; Economic profit is positive or zero or negative

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Perfect Competition in the Long Run

• Long run– All resources are variable

– Firms can enter/exit the market• Number of firms can change

– Firms adjust scale of operations• To maximize long run profits• Until average cost is minimized

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Perfect Competition in the Long Run

• If we have economic profit in short run – New firms enter market in long run

– Existing firms expand in long run

– Market S increases (shift right)• P decreases• Economic profit disappears• Firms break even

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Perfect Competition in the Long Run

• If we have economic loss in short run– Some firms exit the market in long run

– Some firms reduce scale in long run

– Market S decreases (shifts left)• P increases• Economic loss disappears• Firms break even

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Zero Economic Profit in the Long Run

• In LR firms enter, leave, change scale• Market:

– S shifts; P changes

• Firm:– d shifts up and down as P changes

– Long run equilibrium• MR=MC =ATC=LRAC• Normal profit• Zero economic profit

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Long-Run Adjustment to a Change in D

• Effects of an Increase in Demand– Short run

• P increases; d increases• Firms increase quantity supplied• Economic profit exists

– Long run• New firms enter the market• S increases, P decreases• Firm’s d decreases• Normal profit 17

Long-Run Adjustment to a Change in D

• 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 increases• Normal profit 18

The Long-Run Industry Supply Curve

• Short run– change quantity supplied along MC curve

• Long run industry supply curve S*– after firms fully adjust to changing prices

• Constant-cost industry– input prices remain constant as industry

output changes• LRAC doesn’t shift with output• Long run S* curve for industry: horizontal line

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The Long-Run Industry Supply Curve

• Increasing Cost Industry– input costs rise as industry output rises

• average costs increase as output expands

• Effects of an increase in demand• LRAC increases (shifts up) as industry output

increases• Long run S* curve for industry: upward

sloping

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Perfect Competition and Efficiency

• Economic Efficiency– State of affairs where it is not possible to

make one person better off without making another worse off

– Includes productive efficiency and allocative efficiency

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Perfect Competition and 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• Cannot reallocate the goods and services to

increase welfare to society

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Perfect Competition and Efficiency

• In a perfectly competitive equilibrium – the amount the consumer is willing to pay

to consume that last unit is just equal to the value (full opportunity costs) of the resources used to produce that last unit

– Market price is driven down as low as it can go and still cover the full cost of production

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What’s So Perfect About Perfect Competition?

• Consumer surplus– Difference between what the consumer is willing

to pay and the market price

• Producer surplus– Difference between the market price and the

marginal cost of producing– Covers FC and profit

• Gains from voluntary exchange• Consumer and producer surplus• Productive and allocative efficiency• Maximum social welfare 24

Inefficient Production

• If MB to consumer is not equal to MC to producer we see inefficiency

• Deadweight loss– Lost consumer surplus or producer

surplus (not recovered elsewhere) due to inefficient production

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