CHAPTER 12 Perfect Competition

CHAPTER 12

Perfect CompetitionCHAPTER 12

Perfect Competition

Michael ParkinECONOMICS 5e

TM 12-2Copyright © 1998 Addison Wesley Longman, Inc.

Learning Objectives

• Define perfect competition

• Explain how price and output are determined in a competitive industry

• Explain why firms sometimes shut down temporarily and lay off workers


Learning Objectives (cont.)

• Explain why firms enter and leave an industry

• Predict the effects of a change in demand and of a technological advance

• Explain why perfect competition is efficient


Learning Objectives





Perfect Competition

Characteristics of Perfect Competition

• Many firms, each selling an identical product.

• Many buyers.

• No restrictions on entry into the industry.


Perfect Competition

Characteristics of Perfect Competition

• Firms in the industry have no advantage over

potential new entrants.

• Firms and buyers are well informed about

prices of the products of each firm in the

industry.


Perfect Competition

As a result of these characteristics, perfect competitors are price takers.

Price takers

Firms that cannot influence the price of a good or service.


Learning Objectives





Economic Profit and Revenue

The firm’s goal is to maximize economic profit.

Total cost is the opportunity cost - including normal profit.



Total revenue is the value of a firm’s sales.

• Total revenue = P Q

Marginal revenue (MR) • Change in total revenue resulting from a one-unit

increase in quantity sold.

Average revenue (AR)

• Total revenue divided by the quantity sold—revenue per unit sold.

In perfect competition, Price = MR = AR



Suppose Sidney sells his sweaters

in a perfectly competitive market.


Demand, Price, and Revenuein Perfect Competition

Quantity Price Marginal Average

sold (P) Total revenue revenue (Q) (dollars revenue (AR = TR/Q

(sweaters per TR = P Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)

8 25

9 25

10 25

QTRMR /






8 25 200

9 25 225

10 25 250

QTRMR /






8 25 200

9 25 225

10 25 250

QTRMR /

25

25






8 25 200 25

9 25 225 25

10 25 250 25

QTRMR /

25

25


TR

D

S


Quantity (thousandsof sweaters per day)

Quantity (sweaters per day) Quantity (sweaters per day)

Pri

ce (

doll

ars

per

swea

ter)

Pri

ce (

doll

ars

per

swea

ter)

Tot

al r

even

ue (

doll

ar p

er d

ay)

0 9 20 0 10 20 0 9 20

25

50

25 225

50

MR aMarketdemandcurve

Sweater marketSidney’s demandand marginal revenue Sidney’s total revenue

Sidney’sdemandcurve


Learning Objectives





The Firm’s Decisions inPerfect Competition

A firm’s task is to make the maximum economic profit possible, given the constraints it faces.

In order to do so, the firm must make two decisions in the short-run, and two in the long-run.



Short-run A time frame in which each firm has a given plant and the number of firms in the industry is fixed

Long-run A time frame in which each firm can change the size of its plant and decide to enter the industry.



In the short-run, the firm must decide:

• Whether to produce or to shut down.

• If the decision is to produce, what quantity to produce.



In the long-run, the firm must decide:

• Whether to increase of decrease its plant size.

• Whether to stay in the industry or leave it.

We will first address the short-run.


Total Revenue, Total Cost, and Economic Profit

Quantity Total Total Economic (Q) revenue cost profit (sweaters (TR) (TC) (TR – TC)

Per day) (dollars) (dollars) (dollars)

0 01 252 503 754 1005 1256 1507 1758 2009 22510 25011 27512 30013 325


Total Revenue, Total Cost,and Economic Profit



0 0 221 25 452 50 663 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360





0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 248 200 160 409 225 183 4210 250 210 4011 275 245 3012 300 300 013 325 360 -35


TC


Quantity (sweaters per day)

Tot

al r

even

ue &

tota

l cos

t (

doll

ars

per

day)

0 4 9 12

100

300

183

225

TR

Economicloss

Economicprofit =TR - TC

Economicloss




4 9 12-20

0

-40

42

20

Profitmaximizing quantity

Profit/loss

Economicprofit

Economicloss

Prof

it/l

oss

(do

llar

s pe

r da

y)

Economic profit/loss


Marginal Analysis

Using marginal analysis, a comparison is made between a units marginal revenue and marginal cost.


Marginal Analysis

If MR > MC, the extra revenue from selling one more unit exceeds the extra cost.

• The firm should increase output to increase profit.

If MR < MC, the extra revenue from selling one more unit is less than the extra cost.

• The firm should decrease output to increase profit.

If MR = MC economic profit is maximized.


Profit-Maximizing Output

Marginal Marginal revenue cost

Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per profit

(sweaters (TR) additional (TC) additional (TR – TC)per day) (dollars) sweater) (dollars sweater) (dollars)

7 175

8 200

9 225

10 250

11 275






7 175

8 200

9 225

10 250

11 275

25

25

25

25






7 175 141

8 200 160

9 225 183

10 250 210

11 275 245

25

25

25

25






7 175 141

8 200 160

9 225 183

10 250 210

11 275 245

25

25

25

25

19

23

27

35






7 175 141 34

8 200 160 40

9 225 183 42

10 250 210 40

11 275 245 30

25

25

25

25

19

23

27

35



Quantity (sweaters per day) 8 9 10

10

20

30

Mar

gina

l rev

enue

& m

argi

nal c

ost

(do

llar

s pe

r da

y)

MR25

MCProfit-maximizationpoint

Loss from10th sweater

Profit from9th sweater

0


The Firm’s Short-Run Supply Curve

Fixed costs must be paid in the short-run.

Variable-costs can be avoided by laying off workers and shutting down.

Firms shut down if price falls below the minimum of average variable cost.


MR2

MR1

A Firm’s Supply Curve

Quantity (sweaters per day)7 9 10

17

25

31

Mar

gina

l rev

enue

& m

argi

nal c

ost

(do

llar

s pe

r da

y) MC = S

MR0

AVC

s

Shutdown point

0


A Firm’s Supply Curve

Quantity (sweaters per day)7 9 10

17

25

31

Mar

gina

l rev

enue

& m

argi

nal c

ost

(do

llar

s pe

r da

y) S

s

0


Short-Run Industry Supply Curve

Short-run industry supply curve

Shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

It is constructed by summing the quantities supplied by the individual firms.


Industry Supply Curve

Quantity supplied Quantity supplied

Price by Sidney by industry(dollars (sweaters (sweaters

per sweater) per day) per day)

a 17 0 or 7 0 to 7,000

b 2 8 8,000

c 25 9 9,000

d 31 10 10,000


S1

Industry Supply Curve

Quantity (thousands of sweaters per day)6 7 8 9 10

20

30

40

Pri

ce (

dolla

rs p

er s

wea

ter)

0


Output, Price, and Profitin Perfect Competition

Industry demand and industry supply determine the market price and industry output.

Changes in demand bring changes to short-run industry equilibrium.


D3

D2

Short-Run Equilibrium

Quantity (thousands of sweaters per day)6 7 8 9 10

17

25

Pric

e (d

olla

rs p

er s

wea

ter)

S

20

D1

Increase in demand:price rises and firmsincrease production

0

Decrease in demand:price falls and firmsdecrease production


Profits and Losses in the Short-Run

At short-run equilibrium firms may:

• Earn a profit

• Break even

• Incur an economic loss.


Profits and Losses in the Short-Run

If price equals average total cost a firm breaks even.

If price exceeds average total cost, a firm makes an economic profit.

If price is less than average total cost, a firm incurs an economic loss.


Quantity (millions of chips per year)

Pri

ce (

dolla

rs p

er c

hip)

15.00

20.00

25.00

8 10

30.00

AR = MR

MC ATCBreak-evenpoint

Normal profit

0

Three Possible Profit Outcomesin the Short-Run


EconomicProfit

0Quantity (millions of chips per year)

Pri

ce (

dolla

rs p

er c

hip)

15.00

20.33

25.00


9 10

30.00

AR = MR

MC ATC

Economic profit


Economicloss

AR = MR

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

17.00

20.14

25.00


30.00

MC ATC

Economic loss

7 100







Long-Run Adjustments

Forces in a competitive industry ensure only one of these situations is possible in the long-run.

Competitive industries adjust in two ways:

• Entry and exit

• Changes in plant size


Entry and Exit

The prospect of persistent profit or loss causes firms to enter or exit an industry.

If firms are making economic profits, other firms enter the industry.

If firms are making economic losses, some of the existing firms exit the industry.


Entry and Exit

This entry and exit of firms influence price, quantity, and economic profit.

Let’s investigate the effects of firms entering or exiting an industry.


S0

Entry and Exit

Quantity (thousands of sweaters per day)

6 7 8 9 10

Pri

ce (

dolla

rs p

er s

wea

ter)

S2

23

17

20

D1

S1

Entry increasessupply

Exitdecreasessupply

0


Entry and Exit

Important Points

As new firms enter an industry, the price falls and the economic profit of each existing firm decreases.

As firms leave an industry, the price rises and the economic loss of each remaining firm decreases.


Changes in Plant Size

When a firm changes its plant size, it can lower its costs and increase its economic profit.

Let’s see how a firm can increase its profit by increasing its plant size.



Pri

ce (d

olla

rs p

er s

wea

ter)

14

25

40

Plant Size and Long-Run Equilibrium

20

6 8

SRAC0

MC0

MC1 SRAC1

MR0

MR1

LRAC

Long-runcompetitiveequilibrium

m

Short-run profitmaximizing point


Long-Run Equilibrium

Long-run equilibrium occurs in a competitive industry when firms are earning normal profit and economic profit is zero.

Economic profits draw in firms and cause existing firms to expand.

Economic losses cause firms to leave and cause existing firms to scale back.


Long-Run Equilibrium

So in long-run equilibrium in a competitive industry, firms neither enter nor exit the industry and firms neither expand their scale of operation nor downsize.







Changing Tastes and Advancing Technology

Demand has fallen tremendously for tobacco, trains, TV and radio repair, and sewing machines.

Demand has increased dramatically for microwave utensils, paper plates, and flash memories.



What happens in a competitive industry when a permanent change in demand occurs?


P0MR0

ATC

MC

MR1P1

D1

D0

S0

A Decrease in Demand

Quantity

Pric

e

0 Quantity

Pric

e an

d C

ost

P0

Industry Firm

P1

q0q1Q0Q1

S1

Q2


External Economies and Diseconomies

External economies

Factors beyond the control of an individual firm that lower its costs as the industry increases.

External diseconomies

Factors outside the control of a firm that raise the firm’s costs as industry output increases.


External Economies and Diseconomies

We will use this information to develop a

long-run industry supply curve.


Long-Run Changes in Price and Quantity

Constant-cost industry Increasing-cost industry Decreasing-cost industry

Quantity

Pri

ce

P0

Q0

D1

Ps

S0

Quantity

Pri

ce

P0

Q0

D0

D1

Ps

S0

Quantity P

rice

P0

Q0

D0

D1

Ps

S0S1

Qs Qs QsQ1

LSA LSC

P2

Q2

S3

S2

P3

Q3

LSB

D0



Technological change

New technology allows firms to produce at lower costs.

This causes their cost curves to shift downward.

Firms adopting the new technology make an economic profit.

This draws in new technology firms.

Old technology firms disappear, the price falls, and the quantity produced increases.







Competition and Efficiency

Resources are used efficiently when there is:

• Consumer efficiency

• Producer efficiency

• Exchange efficiency



Consumer efficiency is achieved when it is not possible for consumers to become better off — to increase utility — by reallocating their budgets.

• On the household’s demand curve

• External benefits

Producer efficiency occurs when a firm is producing at any point on its marginal cost curve, or equivalently, on its supply curve.

• External costs



Exchange efficiency occurs when all the gains from trade have been realized (i.e. consumer and producer surplus).


Quantity

Pri

ce

P*

Efficiency of Competition

S

D

Q*

Consumersurplus

Producersurplus

B0

Efficient allocation

C0

Q0


Efficiency of Perfect Competition

Perfect competition enables resources to be used efficiently if there are no external benefits and external costs.

• External costs and external benefits

• Goods providing external benefits would be underproduced, while goods providing external costs would be overproduced.

• Monopoly

• Monopoly restricts output below its competitive level to raise price and increase profit.

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CHAPTER 12 Perfect Competition