Perfect Competition

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

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 market

– Sellers offer a standardized product

– Sellers can easily enter into or exit from market

A Large Number of Buyers and Sellers

• In perfect competition, there must be many buyers and sellers–How 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

A Standardized Product Offered by Sellers

• Buyers do not perceive significant differences between products of one seller and another– For instance, buyers of wheat do not

prefer one farmer’s wheat over another

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

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

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

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

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

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

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

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

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

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

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 level– Total Profit = TR - TC

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

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

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

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

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

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

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

Competitive Markets in the Short- Run

• Short-run is a time period too short for firm to vary all of its inputs– Quantity 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

Reference: Introduction to Economics

byLieberman & Hall

Chapter seven: Perfect CompetitionSlides by John F. Hall