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Animations by Anthony ZambelliINTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 7 / PERFECT COMPETITION©2005, South-Western/Thomson Learning
Chapter 7
Perfect Competition
Lieberman & Hall; Introduction to Economics, 2005 2
Perfect Competition To determine structure of any particular market, we begin by
asking How many buyers and sellers are there in the market? Is each seller offering a standardized product, more or less
indistinguishable from that offered by other sellers• Or are there significant differences between the products of different
firms? Are there any barriers to entry or exit, or can outsiders easily enter
and leave this market? Answers to these questions help us to classify a market into
one of four basic types Perfect competition Monopoly Monopolistic Oligopoly
Lieberman & Hall; Introduction to Economics, 2005 3
The Three Requirements of Perfect Competition
Large numbers of buyers and sellers, and Each buys or sells only a tiny fraction of
the total quantity in the marketSellers offer a standardized productSellers can easily enter into or exit from
market
Lieberman & Hall; Introduction to Economics, 2005 4
A Large Number of Buyers and Sellers
In perfect competition, there must be many buyers and sellersHow many?
•Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells
Lieberman & Hall; Introduction to Economics, 2005 5
A Standardized Product Offered by Sellers
Buyers do not perceive significant differences between products of one seller and anotherFor instance, buyers of wheat do not prefer
one farmer’s wheat over another
Lieberman & Hall; Introduction to Economics, 2005 6
Easy Entry into and Exit from the Market
Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and establish contacts with customers But perfectly competitive market has no significant barriers to
discourage new entrants• Any firm wishing to enter can do business on the same terms as firms
that are already there In many markets there are significant barriers to entry
Legal barriers Existing sellers have an important advantage that new entrants can
not duplicate• Brand loyalty enjoyed by existing producers would require a new entrant
to wrest customers away from existing firms Significant economies of scale may give existing firms a cost
advantage over new entrants
Lieberman & Hall; Introduction to Economics, 2005 7
Easy Entry into and Exit from the Market
Perfect competition is also characterized by easy exit A firm suffering a long-run loss must be able to
sell off its plant and equipment and leave the industry for good, without obstacles
Significant barriers to entry and exit can completely change the environment in which trading takes place
Lieberman & Hall; Introduction to Economics, 2005 8
Is Perfect Competition Realistic? Assumptions market must satisfy to be perfectly competitive
are rather restrictive In vast majority of markets, one or more of assumptions of
perfect competition will, in a strict sense, be violated Yet when economists look at real-world markets, they use perfect
competition more often than any other market structure Why is this?
Model of perfect competition is powerful Many markets—while not strictly perfectly competitive—come
reasonably close We can even—with some caution—use model to analyze
markets that violate all three assumptions Perfect competition can approximate conditions and yield
accurate-enough predictions in a wide variety of markets
Lieberman & Hall; Introduction to Economics, 2005 9
Figure 1: The Competitive Industry and Firm
Ounces of Gold per Day
Price per Ounce
D
$400
S
Market
Demand Curve Facing
the Firm
$400
Firm
1. The intersection of the market supply and the market demand curve…
3. The typical firm can sell all it wants at the market price…
Ounces of Gold per Day
Price per Ounce
2. determine the equilibrium market price
4. so it faces a horizontal demand curve
Lieberman & Hall; Introduction to Economics, 2005 10
Goals and Constraints of the Competitive Firm
Perfectly competitive firm faces a cost constraint like any other firm
Cost of producing any given level of output depends on Firm’s production technology Prices it must pay for its inputs
Lieberman & Hall; Introduction to Economics, 2005 11
The Demand Curve Facing a Perfectly Competitive Firm
Panel (b) of Figure 1 shows demand curve facing Small Time Gold Mines Notice special shape of this curve
• It’s horizontal, or infinitely price elastic
Why should this be? In perfect competition output is standardized No matter how much a firm decides to produce, it
cannot make a noticeable difference in market quantity supplied • So cannot affect market price
Lieberman & Hall; Introduction to Economics, 2005 12
The Demand Curve Facing a Perfectly Competitive Firm
Means Small Time has no control over the price of its output Simply accepts market price as given
• In perfect competition, firm is a price taker Treats the price of its output as given and beyond its control
Since a competitive firm takes the market price as given Its only decision is how much output to produce
and sell
Lieberman & Hall; Introduction to Economics, 2005 13
Cost and Revenue Data for a Competitive Firm
For a competitive firm, marginal revenue at each quantity is the same as the market price
For this reason, marginal revenue curve and demand curve facing firm are the same A horizontal line at the market price
Lieberman & Hall; Introduction to Economics, 2005 14
Figure 2(a): Profit Maximization in Perfect Competition
TR
550
$2,800
2,100
TC
Slope = 400
Ounces of Gold per Day
Dollars
1 2 3 4 5 6 7 8 9 10
Maximum Profit per Day = $700
Lieberman & Hall; Introduction to Economics, 2005 15
Figure 2(b): Profit Maximization in Perfect Competition
MC
$400 D = MR
Ounces of Gold per Day
Dollars
1 2 3 4 5 6 7 8 9 10
Lieberman & Hall; Introduction to Economics, 2005 16
The Total Revenue and Total Cost Approach
Most direct way of viewing firm’s search for the profit-maximizing output level
At each output level, subtract total cost from total revenue to get total profit at that output levelTotal Profit = TR - TC
Lieberman & Hall; Introduction to Economics, 2005 17
The Marginal Revenue and Marginal Cost Approach
Firm should continue to increase output as long as marginal revenue > marginal cost
Remember that profit-maximizing output is found where MC curve crosses MR curve from below
Finding the profit-maximizing output level for a competitive firm requires no new concepts or techniques
Lieberman & Hall; Introduction to Economics, 2005 18
Measuring Total Profit Start with firm’s profit per unit
Revenue it gets on each unit minus cost per unit• Revenue per unit is the price (P) of the firm’s output, and cost per
unit is our familiar ATC, so we can write Profit per unit = P – ATC
Firm earns a profit whenever P > ATC Its total profit at the best output level equals area of a
rectangle with height equal to distance between P and ATC, and width equal to level of output
A firm suffers a loss whenever P < ATC at the best level of output Its total loss equals area of a rectangle
• Height equals distance between P and ATC• Width equals level of output
Lieberman & Hall; Introduction to Economics, 2005 19
Figure 3(a): Measuring Profit or Loss
$400300
Profit per Ounce ($100)
d = MR
MC
ATC
Economic Profit
Ounces of Gold per Day
Dollars
1 2 3 4 5 6 7 8
Lieberman & Hall; Introduction to Economics, 2005 20
Figure 3(a): Measuring Profit or Loss
MC
ATC
d = MR$300
200
Loss per Ounce ($100)
Economic Loss
Ounces of Gold per Day
Dollars
1 2 3 4 5 6 7 8
Lieberman & Hall; Introduction to Economics, 2005 21
The Firm’s Short-Run Supply Curve
A competitive firm is a price taker Takes market price as given and then decides how much
output it will produce at that price Profit-maximizing output level is always found by
traveling from the price, across to the firm’s MC curve, and then down to the horizontal axis, or As price of output changes, firm will slide along its MC
curve in deciding how much to produce Exception
If the firm is suffering a loss large enough to justify shutting down
• It will not produce along its MC curve• It will produce zero units instead
Lieberman & Hall; Introduction to Economics, 2005 22
Figure 4: Short-Run Supply Under Perfect Competition
0.50
1,0002,000
4,0005,000
7,000
1.00
2.00
$3.50
2.50
MCATC
d1=MR1
AVC
(a)
Firm's Supply Curve
0.50
2,0004,000
5,000
7,000
1.00
2.00
$3.50
2.50
(b)
d2=MR2
d3=MR3
d4=MR4
d5=MR5
Bushels per Year
Dollars Price per Bushel
Bushels per Year
Lieberman & Hall; Introduction to Economics, 2005 23
The Shutdown Price Price at which a firm is indifferent between producing and
shutting down Can summarize all of this information in a single curve—
firm’s supply curve Tells us how much output the firm will produce at any price
Supply curve has two parts For all prices above minimum point on its AVC curve, supply curve
coincides with MC curve For all prices below minimum point on AVC curve, firm will shut
down• So its supply curve is a vertical line segment at zero units of output
For all prices below $1—the shutdown price—output is zero and the supply curve coincides with vertical axis
Lieberman & Hall; Introduction to Economics, 2005 24
Competitive Markets in the Short- Run
Short-run is a time period too short for firm to vary all of its inputsQuantity of at least one input remains fixed
Let’s extend concept of short-run from firm to market as a whole
Conclusion In short-run, number of firms in industry is
fixed
Lieberman & Hall; Introduction to Economics, 2005 25
The (Short-Run) Market Supply Curve
Once we know how to find supply curve of each individual firm in a market Can easily determine the short-run market supply curve
• Shows amount of output that all sellers in market will offer at each price
To obtain market supply curve sum quantities of output supplied by all firms in market at each price
As we move along this curve, we are assuming that two things are constant Fixed inputs of each firm Number of firms in market
Lieberman & Hall; Introduction to Economics, 2005 26
Short-Run Equilibrium
How does a perfectly competitive market achieve equilibrium? In perfect competition, market sums buying and
selling preferences of individual consumers and producers, and determines market price• Each buyer and seller then takes market price as
given Each is able to buy or sell desired quantity
Competitive firms can earn an economic profit or suffer an economic loss
Lieberman & Hall; Introduction to Economics, 2005 27
Figure 6: Perfect Competition
Quantity Demanded at
Different Prices
Quantity Supplied at
Different Prices
Quantity Supplied by Each Firm
Quantity Demanded by
Each Consumer
Individual Demand
Curve
Individual Supply Curve
Quantity Demanded by All Consumers at
Different Prices
Quantity Supplied by All Firms at Different
Prices
Market Demand
Curve
Market Supply Curve
P S
D
Q
Market Equilibrium
Added together Added together
Lieberman & Hall; Introduction to Economics, 2005 28
Figure 7: Short-Run Equilibrium in Perfect Competition
400,000 700,000
2.00
$3.50
S
D1
D2
MC
d1
d2
ATC
7,0004,000
2.00
$3.50
3. If the demand curve shifts to D2 and the market equilibrium moves here . . .
4. the typical firm operates here and suffers a short-run loss.
2. the typical firm operates here, earning economic profit in the short run.
1. When the demand curve is D1 and market equilibrium is here . . .
Profit per Bushel at p = $3.50
Price per Bushel
Market
Bushels per Year
DollarsFirm
Bushels per Year
Loss per Bushel at p = $2
Lieberman & Hall; Introduction to Economics, 2005 29
Profit and Loss and the Long Run
In a competitive market, economic profit and loss are the forces driving long-run change Expectation of continued economic profit (losses) causes outsiders
(insiders) to enter (exit) the market In real world entry and exit occur literally every day
In some cases, we see entry occur through formation of an entirely new firm
Entry can also occur when an existing firm adds a new product to its line
Exit can occur in different ways Firm may go out of business entirely, selling off its assets and
freeing itself once and for all from all costs Firm switches out of a particular product line, even as it continues to
produce other things
Lieberman & Hall; Introduction to Economics, 2005 30
From Short-Run Profit to Long-Run Equilibrium
As we enter long-run, much will change Economic profit will attract new entrants
• Increasing number of firms in market As number of firms increases, market supply curve will shift
rightward causing several things to happen Market price begins to fall As market price falls, demand curve facing each firm
shifts downward Each firm—striving as always to maximize profit—will
slide down its marginal cost curve, decreasing output
Lieberman & Hall; Introduction to Economics, 2005 31
From Short-Run Profit to Long-Run Equilibrium
This process of adjustment—in the market and the firm—continues until…well, until when? When the reason for entry—positive profit—no longer
exits Requires market supply curve to shift rightward enough,
and the price to fall enough• So that each existing firm is earning zero economic profit
In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero
Lieberman & Hall; Introduction to Economics, 2005 32
Figure 8(a/b): From Short-Run Profit To Long-Run Equilibrium
S1
d1ATC
MC
$4.50
With initial supply curve S1, market price is $4.50…
$4.50
900,000 9,000
So each firm earns an economic profit.
AA
Price per Bushel
Market
Bushels per Year
Dollars
Firm
Bushels per Year
D
Lieberman & Hall; Introduction to Economics, 2005 33
Figure 8(c/d): From Short-Run Profit To Long-Run Equilibrium
S1
d1ATC
MC
$4.50
Profit attracts entry, shifting the supply curve rightward…
$4.50
900,000 9,0005,000
until market price falls to $2.50 and each firm earns zero economic profit.
S2
d1
AA
2.502.50EE
Market Firm
Price per Bushel
Bushels per Year
Dollars
Bushels per Year
D
1,200,000
Lieberman & Hall; Introduction to Economics, 2005 34
From Short-Run Loss to Long-Run Equilibrium
What if we begin from a position of loss? Same type of adjustments will occur, only in the opposite
direction
In a competitive market, economic losses continue to cause exit until losses are reduced to zero
When there are no significant barriers to exit Economic loss will eventually drive firms from the
industry• Raising market price until typical firm breaks even again
Lieberman & Hall; Introduction to Economics, 2005 35
Distinguishing Short-Run from Long-Run Outcomes
In short-run equilibrium, competitive firms can earn profits or suffer losses In long-run equilibrium, after entry or exit has occurred, economic
profit is always zero When economists look at a market, they automatically think
of short-run versus long-run Choose the period more appropriate for the question at hand
Basic Principle #7: Short-Run versus Long-Run Outcomes Markets behave differently in the short-run and the long run In solving a problem, we must always know which of these time
horizons we are analyzing
Lieberman & Hall; Introduction to Economics, 2005 36
The Notion of Zero Profit in Perfect Competition
We have not yet discussed plant size of competitive firm
The same forces—entry and exit—that cause all firms to earn zero economic profit also ensure In long-run equilibrium, every competitive firm
will select its plant size and output level so that it operates at minimum point of its LRATC curve
Lieberman & Hall; Introduction to Economics, 2005 37
Perfect Competition and Plant Size
Figure 9(a) illustrates a firm in a perfectly competitive market But panel (a) does not show a true long-run equilibrium How do we know this?
• In long-run typical firm will want to expand• Why?
Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit
By expanding firm could potentially earn an economic profit
• Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset
Entry and expansion must continue in this market until the price falls to P* Because only then will each firm—doing the best that it can do—
earn zero economic profit
Lieberman & Hall; Introduction to Economics, 2005 38
Figure 9: Perfect Competition and Plant Size
P1
q1
d1 = MR1
LRATCMC1 ATC1
E
d2 = MR2
LRATC
MC2 ATC2
P*
q*4. and all firms earn zero economic profit and produce at minimum LRATC.
.
Dollars Dollars
Output per Period
Output per Period
3. As all firms increase plant size and output, market price falls to its lowest possible level . . .
1. With its current plant and ATC curve, this firm earns zero economic profit.
2. The firm could earn positive profit with a larger plant, producing here.
Lieberman & Hall; Introduction to Economics, 2005 39
A Summary of the Competitive Firm in the Long-Run
Can put it all together with a very simple statement At each competitive firm in long-run equilibrium
• P = MC = minimum ATC = minimum LRATC
In figure 9(b), this equality is satisfied when the typical firm produces at point E Where its demand, marginal cost, ATC, and LRATC
curves all intersect In perfect competition, consumers are getting the
best deal they could possibly get
Lieberman & Hall; Introduction to Economics, 2005 40
A Change in Demand Short-run impact of an increase in demand is
Rise in market price Rise in market quantity Economic profits
What happens in long-run after demand curve shifts rightward? Market equilibrium will move from point A to point C
Long-run supply curve Curve indicating quantity of output that all sellers in a
market will produce at different prices• After all long-run adjustments have taken place
Lieberman & Hall; Introduction to Economics, 2005 41
Figure 10: An Increasing-Cost Industry
INITIAL EQUILIBRIUM
D1
S1
AP1
Q1
P1
q1
MC
A
ATC1
d1 = MR1
Output per Period
MarketDollars
Firm
Output per Period
Price per Unit
Lieberman & Hall; Introduction to Economics, 2005 42
Figure 10: An Increasing-Cost Industry
NEW EQUILIBRIUM
MC
ATC1
DollarsFirm
P1
q1
Ad1 = MR1
Output per Period
Market
S1
Output per Period
Price per Unit
D1
AP1
Q1
dSR = MRSR
d2 = MR2P2
PSR
P2
PSR ATC2C
BB
C
QSR Q2q1 q1
S2
SLR
D2
Lieberman & Hall; Introduction to Economics, 2005 43
Increasing, Decreasing, and Constant Cost Industries
Increase in demand for inputs causes price of those inputs to rise
This type of industry (which is the most common) is called an increasing cost industry Entry causes input prices to rise
• Shifts up typical firm’s ATC curve Raises market price at which firms earn zero economic profit
As a result, long-run supply curve slopes upward
Lieberman & Hall; Introduction to Economics, 2005 44
Increasing, Decreasing, and Constant Cost Industries
Other possibilities Industry might use such a small percentage of total inputs that—
even as new firms enter—there is no noticeable effect on input prices
• Called a constant cost industry Entry has no effect on input prices, so typical firm’s ATC curve stays put
Market price at which firms earn zero economic profit does not change Long-run supply curve is horizontal
Decreasing cost industry, in which entry by new firms actually decreases input prices
• Entry causes input prices to fall Causes typical firm’s ATC curve to shift downward
Lowers market price at which firms earn zero economic profit As a result, long-run supply curve slopes downward
Lieberman & Hall; Introduction to Economics, 2005 45
Market Signals and the Economy
In real world, demand curves for different goods and services are constantly shifting
As demand increases or decreases in a market, prices change
Economy is driven to produce whatever collection of goods consumers prefer
In a market economy, price changes act as market signals, ensuring that pattern of production matches pattern of consumer demands When demand increases, a rise in price signals firms to enter
market, increasing industry output When demand decreases, a fall in price signals firms to exit market,
decreasing industry output
Lieberman & Hall; Introduction to Economics, 2005 46
Market Signals and the Economy
Market signal Price changes that cause firms to change their
production to more closely match consumer demand No single person or government agency directs this
process This is what Adam Smith meant when he suggested that
individual decision makers act for the overall benefit of society
• Even though, as individuals, they are merely trying to satisfy their own desires
• As if guided by an invisible hand