Perfect Competition CHAPTER 14. Alfred P. Sloan. There s no resting place for an enterprise in a competitive economy. Perfect Competition 14

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1 CHATER 14 erfect Competition There s no resting place for an enterprise in a competitive economy. Alfred. Sloan McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 A erfectly Competitive Market Characteristics of a perfectly competitive market: 1. Both buyers and sellers are price takers A price taker is a firm or individual who takes the price determined by market supply and demand as given If a firm charges above the market price consumers will buy from their competition (and will make no McGraw-Hill/Irwin Colander, Economics 2 revenue)

3 A erfectly Competitive Market 2. The number of firms is large 3. There are NO barriers to entry Easy entry and exit McGraw-Hill/Irwin Colander, Economics 3

4 A erfectly Competitive Market 4. Firms products are identical (that means the competitor s goods are perfect substitutes) 5. There is complete information Consumers know all about the market including prices, products, and available technology 14-4

5 A erfectly Competitive Market 6. Firms are profit-maximizing =D=MR=AR The demand curve will be perfectly elastic (the firm is a price taker) rice will be determined by market equilibrium Marginal revenue is the same as price (the amount of revenue you get from selling each additional unit) McGraw-Hill/Irwin Colander, Economics 5

6 The Definition of Supply in erfect Competition When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost 14-6

7 Demand Curves in erfect Competition The market/industry demand curve is downward sloping The firm s demand curve is a horizontal line a perfectly elastic demand curve McGraw-Hill/Irwin Colander, Economics 7

8 Demand Curves in erfect Competition WHY??? The firms demand curve is derived from market equilibrium price We consider the demand curve to be horizontal because price is the same no matter how much is produced McGraw-Hill/Irwin Colander, Economics 8

9 Side-by-side Graphs for erfect Competition Market/Industry and the Firm When drawing the graphs for perfectively competitive markets keep in mind that you are always drawing 2 graphs: one for the entire market and one for a firm We call these graphs side-by-side graphs The price, demand, and marginal revenue of the firm are derived from market price at equilibrium McGraw-Hill/Irwin Colander, Economics 9

10 Side-by-side Graphs for erfect Competition Market/Industry and the Firm Market demand is downward sloping Firm demand is perfectly elastic (horizontal) S 1 1 = D = MR = AR D Q Q Q

11 erfect Competition in the Short-Run The firm graph looks like this: Market Firm erfect Competition 14 Add MC and ATC to your graph MC S ATC 1 = D = MR = AR The big dot Q 1 D Q Q profit max Q 14-11

12 rofit Maximizing Level of Output The goal of the firm is to maximize profits rofit=tr-tc (Total revenue Total costs) 14-12

13 rofit Maximizing Level of Output (continued) A firm maximizes profit when marginal revenue equals marginal cost 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 change in quantity McGraw-Hill/Irwin Colander, Economics 13

14 rofit Maximizing Level of Output (continued) So, the profit-maximizing condition of a perfectly competitive firm is: MR = MC For a perfectly competitive firm, MR = As a result, MC=MR= This is the profit-maximizing condition 14-14

15 rofit Maximizing Level of Output (continued) A firm maximizes total profit, not profit per unit If MR > MC, a firm can increase profit by increasing output If MR < MC, a firm can increase profit by decreasing its output McGraw-Hill/Irwin Colander, Economics 15

16 Marginal Cost, Marginal Revenue, and rice Table rice = MR ($) Q Marginal Cost ($) The profit-maximizing condition of a competitive firm is: MC = MR = If MC <, increase production rofit maximizing quantity is where MC = If MC >, decrease production 14-16

17 Marginal Cost, Marginal Revenue, and rice Graph Marginal Cost MC = MC >, decrease output to increase total profit $35 = D = MR=AR MC <, increase output to increase total profit MC = at 8 units, total profit is maximized Q 14-17

18 The Marginal Cost Curve is the Supply Curve Marginal Cost = Firm s Supply Curve $61 $35 $ Because the marginal cost curve tells us how much of a good a firm will supply at a given price, the marginal cost curve is the firm s supply curve (above AVC) Q 14-18

19 rofit Maximization Using Total Revenue and Total Cost An alternative method to determine the profit-maximizing level of output is to look at the total revenue and total cost curves Total cost is the cumulative sum of the marginal costs, plus the fixed costs Total profit is the difference between total revenue and total cost curves 14-19

20 Total Revenue and Total Cost Table Total Cost, Total Revenue $280 $175 Max profit = $81 at 8 units of output TC TR The total revenue curve is a straight line The total cost curve is bowed upward at most quantities reflecting increasing marginal cost $130 Losses 3 5 rofits 8 Losses Q rofits are maximized when the vertical distance between TR and TC is greatest 14-20

21 Total Revenue and Total Cost Table (not in your notes) Q Total Revenue ($) Total Cost ($) Total rofit ($) erfect Competition 14 Total profit is maximized at 8 units of output 14-21

22 erfect Competition: Firm Graphs You Must Know A Firm with rofit in the Short Run rofits MC ATC = D = MR = AR Find output where MC = MR, this is the profit maximizing Q put a BIG dot there Find profit per unit where the profit max Q intersects ATC Q profit max Q Since >ATC at the profit maximizing quantity, this firm is earning profits 14-22

23 erfect Competition: Graphs You Must Know A Firm with a Loss Losses Q profit max MC ATC = D = MR = AR Q Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC Since <ATC at the profit maximizing quantity, this firm is earning a loss 14-23

24 erfect Competition: Graphs You Must Know A Firm with Zero rofit or Loss (Normal rofit) Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC MC ATC = D = MR = AR Since =ATC at the profit maximizing quantity, this firm is earning zero profit or loss Q profit max Q 14-24

25 The Shutdown oint for erfect Competitors In the short run, fixed costs are sunk costs they must be paid whether or not the firm produces anything The firms pays attention to its variable costs when deciding to shutdown As long as a firm is covering its variable costs it should still produce When price falls below AVC is when the firm should shutdown McGraw-Hill/Irwin Colander, Economics 25

26 erfect Competition: The Shutdown Decision The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business If >min of AVC, then the firm will still produce, but earn a loss If <min of AVC, the firm will shut down If a firm shuts down, it still has to pay its fixed costs Shutdown Q profit max MC ATC AVC = D = MR = AR Q 14-26

27 erfect Competition in the Short-Run Can make a profit erfect Competition 14 Market Firm MC S ATC e rofits = D = MR = AR D Q Q Q e Q profit max 14-27

28 erfect Competition in the Long-Run In the long run perfect competitors make zero economic profits WHY??? Due to the entry and exit of firms If a profit was being made firms would keep entering the market 14-28

29 erfect Competition in the Long-Run Zero profit does not mean that the entrepreneur does not get anything for his efforts Normal profit is the amount the owners would have received in their next best alternative (breakeven point; TR=TC) Economic profits are profits above normal profits (where TR exceeds TC) 14-29

30 Market Response to an Increase in Demand Graph Market Firm S 1 MC ATC SR rofits D 2 = 2 =MR 2 =AR 2 D 1 = 1 =MR 1 =AR 1 D 2 Q 1 Q 2 D 1 Q Q 1 Q 2 Q 14-30

31 erfect Competition: ractice MC ATC = D = MR = AR Is this firm making a profit, loss, or zero economic profit? Shade the area that represents total costs Q profit max Q 14-31

32 erfect Competition: ractice rofit MC ATC = D = MR = AR Is this firm making a profit, loss, or zero economic profit? rofit Shade the area that represents total costs Grey box Total costs Q profit max Q 14-32

33 A Note About erfect Competition for FRQs Firms can be in a constant-cost industry OR an increasing cost industry In the constant-cost industry we assume that the entry and exit of firms has no impact on the cost curves of the firms in the market McGraw-Hill/Irwin Colander, Economics 33

34 A Note About erfect Competition for FRQs In an increasing cost industry we assume that the entrance of new firms increases the demand for the factors of production This might increase the cost of employing those resources When this happens, the cost curves shift upward McGraw-Hill/Irwin Colander, Economics 34

35 A Note About erfect Competition for FRQs Graphically, what would happen in an increasing cost industry? The entrance of new firms would drive down the price of output and increase the cost curves profit would be eliminated more quickly here than in a constant-cost industry The new long run price would be higher than in a constant-cost industry McGraw-Hill/Irwin Colander, Economics 35

36 A Note About erfect Competition for FRQs The other option is a decreasing cost industry (yet to see this in the FRQs) This is when the entry of new firms decreases the price of key inputs and causes the cost curves to shift downward Could be due to economies of scale and lower per unit-costs McGraw-Hill/Irwin Colander, Economics 36

37 A Note About erfect Competition for FRQs The entrance of new firms lowers the price of the output and decrease the cost curves Takes longer for profit to be eliminated than in the constant-cost industry More firms can enter this market and the new long run price would be lower than in a constant cost industry McGraw-Hill/Irwin Colander, Economics 37

38 Chapter Summary The necessary conditions for perfect competition are: 1. Buyers and sellers are price takers 2. The number of firms is large 3. There are no barriers to entry 4. Firms products are identical 5. There is complete information 6. Sellers are profit-maximizing entrepreneurial firms 14-38

39 Chapter Summary Competitive firms maximize profit where MR = MC rofit is ( ATC)(Q) at the profit-maximizing level of output erfectly competitive firms shut down if < AVC The supply curve of a competitive firm is its MC curve above minimum AVC The short-run market supply curve is the horizontal sum of the MC curves above AVC for all the firms in the market 14-39

40 Chapter Summary In the short run, competitive firms can make a profit or loss. In the long run they make zero profits. If there are profits: Firms enter the industry Supply increases rice decreases, eliminating profit If there are losses: Firms leave the industry Supply decreases rice increases, eliminating losses 14-40

41 Chapter Summary The long-run industry supply curve is a schedule of quantities supplied where firms are making zero profit Constant-cost industries have horizontal long-run supply curves Increasing-cost industries have upward sloping longrun supply curves Decreasing-cost industries have downward sloping supply curves The slope of the long-run supply curve depends on what happens to factor costs when output increases 14-41