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Chapter 2 ECON4 William A. McEachern
1© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect
Competition
2
Introduction to Perfect Competition
• Market structure
– Number of suppliers
– Product’s degree of uniformity
– Ease of entry into the market
– Forms of competition among forms
• A firm’s decisions
– How much to produce; what price to
charge
– Depend on the structure of the market© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfectly Competitive Market
• Perfect competition
– Many buyers and sellers
– Commodity; standardized product
– Fully informed buyers and sellers
– No barriers to entry
• Individual buyer or seller
– No control over price
– Price takers
3© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Demand under Perfect Competition
• Market price
– Determined by supply and demand
• Demand curve facing one supplier
– Horizontal line at the market price
– Perfectly elastic
4© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Demand under Perfect Competition
• Price taker
– Firm that faces a given market price
• Its quantity supplied has no effect on that
price
– Perfectly competitive firm that decides to
produce
• Must accept, or “take,” the market price
5© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1
6
Market equilibrium & firm’s demand curve in perfect competitionP
rice p
er
bushel
$5
D
S
(a) Market equilibrium
Price p
er
bushel
$5 d
(b) Firm’s demand
1,200,000 Bushels of
wheat per day
0 15 Bushels of
wheat per day
0 5 10
In panel (a), the market price of $5 is determined by the intersection of the market
demand and market supply curves. A perfectly competitive firm can sell any amount
at that price. The demand curve facing the perfectly competitive firm is horizontal at
the market price, as shown by demand curve d in panel (b).
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Short Run Profit Maximization
• Maximize economic profit
– Quantity at which total revenue exceeds
total cost by the greatest amount
• Total revenue, TR
• Total cost, TC
• Profit = TR – TC
• If TR > TC: economic profit
• If TC > TR: economic loss
7© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Short Run Profit Maximization
• Marginal revenue, MR
• Average revenue, AR
– Total revenue divided by quantity
• MR = P = AR
– Along a perfectly competitive firm’s
demand curve
• Marginal cost, MC
8© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Short Run Profit Maximization
• Maximize economic profit:
– Increase production as long as each
additional unit adds more to TR than TC
• Golden rule
– Expand output: MR>MC
– Stop before MC>MR
9© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 2
10
Maximizing Short-Run Profit for a Perfectly Competitive Firm
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 3
11
Short-run profit maximization for a perfectly competitive firm
Total cost Total revenue
(=$5 × q)
Tota
l dolla
rs $60
48
15
Bushels of wheat per day0 5 7 10 12 15
Do
llars
pe
r b
ush
el
$5
4
Bushels of wheat per day0 5 7 10 12 15
(a) Total revenue minus total cost
(b) Marginal cost equals marginal revenue
Average total cost
d = Marginal revenue
= Average revenue
Marginal cost
Maximum economic
profit = $12
In panel (a), the total revenue curve for
a perfectly competitive firm is a straight
line with a slope of 5, the market price.
Total cost increases with output, first at a
decreasing rate and then at an
increasing rate. Economic profit is
maximized where total revenue exceeds
total cost by the greatest amount, which
occurs at 12 bushels of wheat per day.
a
e
Profit
In panel (b), marginal revenue is a
horizontal line at the market price
of $5. Economic profit is
maximized at 12 bushels of wheat
per day, where marginal revenue
equals marginal cost (point e).
That profit equals 12 bushels
multiplied by the amount by which
the market price of $5 exceeds the
average total cost of $4. Economic
profit is identified by the shaded
rectangle.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Minimizing Short-Run Losses
• Total cost, TC = FC+VC
• Shut down in short run: pay fixed cost
• If TC<TR: economic loss
– Produce if TR>VC (P>AVC)
• Revenue covers variable costs and a portion
of fixed cost
• Loss < fixed cost
– Shut down (short run) if TR<VC (P<AVC)
• Loss = FC
12© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 4
13
Minimizing Short-Run Losses for a Perfectly Competitive Firm
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5
14
Short-Run Loss Minimization for a Perfectly Competitive Firm
Total cost Total revenue
(=$3 × q)
Tota
l dolla
rs
$40
30
15
Bushels of wheat per day0 5 10 15
(a) Total revenue minus total cost
(b) Marginal cost equals marginal revenue
Average total cost
d = Marginal revenue
= Average revenue
Marginal cost
Minimum economic
loss = $10
Because total cost always
exceeds total revenue in
panel (a), the firm suffers a
loss no matter how much is
produced. The loss is
minimized where output is
10 bushels per day. Panel
(b) shows that marginal
revenue equals marginal
cost at point e. The loss is
equal to output of 10
multiplied by the difference
between average total cost
($4) and price ($3).
Because price exceeds
average variable cost
($2.50), the firm is better off
continuing to produce in the
short run, since revenue
covers some fixed cost.
eLoss
Bushels of wheat per day0 5 10 15
Dolla
rs p
er
bushel
$4.00
3.00
2.50
Average variable cost
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Firm & Industry Short-Run S Curves
• Short-run firm supply curve
– How much firms supply in the short run
– Upward sloping portion of firm’s MC curve
– Above minimum AVC curve
• Short-run industry supply curve
– Quantity supplied by industry at each
price in the short run
– Horizontal sum of all firms’ short-run
supply curves
15© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 6
16
Summary of a perfectly competitive firm’s short-run output decisions
Average total cost
Average variable cost
Marginal cost
d1
d2
d3
d4
d5
1
2
3
4
5
q2 q3 q4 q5q1 Quantity per period
p2
p1
p3
p4
p5
0
Dolla
rs p
er
unit
Shutdown
point
Break-even
point
At p4, the firm produces q4 and just breaks even, earning a normal profit, because p4 equals
average total cost. Finally, at p5, the firm produces q5 and earns an economic profit. The firm’s
short-run supply curve is that portion of its marginal cost curve at or rising above the minimum
point of average variable cost (point 2).
Firm’s short run S curve
At price p1, the firm produces
nothing because p1 is less
than the firm’s average
variable cost. At price p2, the
firm is indifferent between
shutting down or producing
q2 units of output, because in
either case, the firm suffers a
loss equal to its fixed cost. At
p3, it produces q3 units and
suffers a loss that is less
than its fixed cost.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 7
17
Aggregating individual supply curves of perfectly competitive
firms to form the market supply curve
10 20
Quantity per period
0
p
p’
Price p
er
unit sA
(a) Firm A
10 200
p
p’
sB
(b) Firm B
10 20
Quantity per period
0
p
p’
sC
(c) Firm C
30 60
Quantity per period
0
p
p’
sA + sB + sC = S
(d) Industry, or market, supply
At price p, each firm supplies 10 units of output & market supplies 30 units. In general, the market
supply curve in panel (d) is the horizontal sum of the individual firm supply curves sA, sB, and sC.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Firm Supply & Market Equilibrium
• Short run, perfect competition
– Market converges to equilibrium P and Q
– Firm
• Max profit
• Min loss
• Shuts down temporarily
18© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8
19
Short-Run Profit Maximization and Market Equilibrium in
Perfect Competition(a) Firm
d
(b) Industry, or market
1,200,000Bushels of
wheat per day012
Bushels of
wheat per day0 5 10
MC = s
ATC
AVC
Dolla
rs p
er
unit
$5
4 Price p
er
unit
$5Profit
∑ MC = S
D
The market supply curve S in panel (b) is the horizontal sum of the supply curves of all 100,000
firms in this perfectly competitive industry. The intersection of S with the market demand curve D
determines the market price of $5. That price, in turn, determines the height of the perfectly elastic
demand curve facing the individual firm in panel (a). That firm produces 12 bushels per day
(where marginal cost equals marginal revenue of $5) and earns economic profit in the short run of
$1 per bushel, or $12 in total per day.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition in Long Run
• Long run
– Firms enter/exit the market
– Firms adjust scale of operations
• Until average cost is minimized
– All resources are variable
20© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition in Long Run
• Economic profit in short run
– New firms enter the market in long run
– Existing firms expand in long run
– Market supply increases
• Price decreases
• Economic profit disappears
• Firms break even
21© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition in Long Run
• Economic loss in short run
– Some firms exit the market in long run
– Some firms reduce scale in long run
– Market supply decreases
• Price increases
• Economic loss disappears
• Firms break even
22© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Zero Economic Profit in Long Run
• Firms enter, leave, change scale
• Market:
– S shifts; P changes
• Firm
– d(P=MR=AR) shifts
– Long run equilibrium
• MR=MC =ATC=LRAC
• Normal profit
• Zero economic profit
23© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 9
24
Long-run equilibrium for a firm & industry in perfect competition
(a) Firm
d
(b) Industry, or market
QQuantity
per period0q
Quantity
per period0
MC
ATC
Dolla
rs p
er
unit
p
Price p
er
unit
p
S
D
LRAC
In long-run equilibrium, the firm produces q units of output per period and earns a normal
profit. At point e, price, marginal cost, marginal revenue, short-run average total cost, and
long-run average cost are all equal. There is no reason for new firms to enter the market
or for existing firms to leave. As long as the market demand and supply curves remain
unchanged, the industry will continue to produce a total of Q units of output at price p.
e
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Long-Run Adjustment
• Effects of an Increase in Demand
– Short run
• P increases; d increases
• Firms increase quantity supplied
• Economic profit
– Long run
• New firms enter the market
• S increases, P decreases
• Firm’s d curve decreases
• Normal profit25© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 10
26
Long-run Adjustment in Perfect Competition to an Increase
in Demand(a) Firm
d
(b) Industry, or market
MC
ATC
S
D
LRAC
D’
a
b
Price p
er
unit
p
p’
Qa
Quantity
per period0 Qb Qc
Dolla
rs p
er
unit
p
p’ d’
qQuantity
per period0 q’
Profit
An increase in market demand from D to D’ in panel (b) moves the short-run market equilibrium point
from a to b. Output increases to Qb, and price rises to p. The price rise shifts up the individual firm’s
demand curve from d to d’ in panel (a). The firm responds to the higher price by increasing output to q
and earns economic profit identified by the shaded rectangle. Economic profit attracts new firms to the
industry in the long run. Market supply shifts right to S’ in panel (b), pushing the market price back down
to p. In panel (a), the firm’s demand curve shifts back down to d, erasing economic profit. The short-run
adjustment is from point a to point b in panel (b), but the long-run adjustment is from point a to point c.
S’
c S*
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Long-Run Adjustment
• 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 curve increases
• Normal profit27© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 11
28
Long-Run Adjustment in Perfect Competition to a Decrease
in Demand(a) Firm
d
(b) Industry, or market
MC
ATC
SD
LRAC
D’’
a
f
Price p
er
unit
p
p’’
Qg
Quantity
per period0 Qf Qa
Dolla
rs p
er
unit
p
p’’ d’’
qQuantity
per period0 q’’
Loss
A decrease of demand to D” in panel (b) disturbs the long-run equilibrium at point a. The price
drops to p” in the short run; output falls to Qf. In panel (a), the firm’s demand curve shifts down
to d. Each firm cuts output to q” and suffers a loss. As firms leave the industry in the long run,
the market supply curve shifts left to S”. Market price rises to p as output falls further to Qg. At
price p, the remaining firms once again earn a normal profit. Thus, the short-run adjustment is
from point a to point f in panel (b); the long-run adjustment is from point a to point g.
S’’
gS*
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Long-Run Industry Supply Curve
• Short run
– Change quantity supplied along MC curve
• Long run industry supply curve, S*
– After firms fully adjust
• Constant-cost industries
– LRAC doesn’t shift with output
– Long run S* curve for industry: straight
horizontal line
29© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Increasing Cost Industries
– Average costs increase as output expands
• Effects of an increase in demand
– Short run
• P increases; d increases
• Firms increase q; Economic profit
– Long run
• New firms enter the market;
• Market: S increases; P decreases
• Firm: MC and ATC increase; d curve
decreases; Zero economic profit30© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 12
31
Long-Run Adjustment for an Increasing-Cost Industry
(a) Firm
da
(b) Industry, or marketMC
ATC
S
D
D’
a
b
Qa
Quantity per
period0 Qb Qc
db
qQuantity per
period0 qb
S’
c
Pri
ce p
er
unit
pa
pb
pc
Do
llars
pe
r un
it
pa
pb
pc
S*
dc
a
b ATC’
MC’
c
An increase in demand to D’ in panel (b) disturbs the initial equilibrium at point a. Short-run equilibrium is at
point b, where D’ intersects the short-run market supply curve S. At the higher price pb, the firm’s demand
curve shifts up to db, and its output increases to qb in panel (a). At point b, the firm is now earning economic
profit, which attracts new firms. As new firms enter, input prices get bid up, so each firm’s marginal and
average cost curves rise. New firms increase the short-run market supply curve from S to S’. The intersection
of the new market supply curve, S’, with D’ determines the market price, pc. At pc, individual firms are earning
a normal profit. Point c shows the long-run equilibrium. By connecting long-run equilibrium points a and c in
panel (b), we obtain the upward-sloping long-run market supply curve S* for this increasing-cost industry.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition & 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
• Allocative efficient market
32© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition
• Consumer surplus
– Consumers pay less (P)
– Than they are willing to pay (along D
curve)
• Producer surplus
– Producers are willing to accept less
(along S curve; MC)
– Than what they are receiving (P)
33© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Perfect Competition
• Gains from voluntary exchange
– Consumer and producer surplus
– Productive and allocative efficiency
– Maximum social welfare
• Social welfare
– Overall well-being of people in the
economy
– Maximized when: marginal cost of
production = marginal benefit to consumers
34© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 13
35
Consumer Surplus and Producer Surplus for Perfectly
Competitive Market
0 100,000120,000
200,000Quantity
per period
$10
6
5
Dolla
rs p
er
unit
S
D
e
m
Consumer
surplus
Producer
surplus
Consumer surplus is represented by
the area above the market-clearing
price of $10 per unit and below the
demand curve; it appears as the blue
triangle. Producer surplus is
represented by the area above the
short-run market supply curve and
below the market-clearing price of
$10 per unit; it appears as the gold
area. At a price of $5 per unit, there
would be no producer surplus. At a
price of $6 per unit, producer surplus
would be the gold shaded area
between $5 and $6. A price of $5 just
covers each firm’s average variable
cost.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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