CHAPTER 14

Perfectly Competitive Markets:Short-Run Analysis

Objective• Analyze the firm’s output decision in a perfectly

competitive market in the short run (sr)

• Analyze the market effects of different policies

Properties of Perfectly Competitive markets

• Large number of firms • Large number of buyers• Free entry and exit• Homogenous product• Perfect information

• This implies:• No market power• Firms take the market price as given

Competitive Markets in the SR• Short run

• One input – fixed• Number of firms – fixed

• The firm faces a horizontal demand or price line• P=MR=AR

• Profit-maximizing quantity?

4

Cost and demand for a competitive firm

5

Price, Cost

In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost.

MC ATC

AVC

Quantity 0

e

b

q3

p1 p1=MR1=AR1

d

q”q’

q’+1

c

Shut down or stay in businessWhat should the firm do if the market price does not cover its average cost? Shut down?

• Shut down if Profit if in business <Profit if shut down

TR-VC-FC < 0-FCTR<VC

The firm should shut down if the revenue is less than the variable cost of production since fixed costs are sunk costs.

Simplify further and divide both sides by Q:TR/Q < VC/Q

Therefore, the firm shuts down if P < AVC

The Shut Down Price

7

Price, Cost

The shut down price is at the min of the AVC curve

MC ATC

AVC

Quantity 0

e

b

a

d

q”

p0 Shut down pricep’0 produce nothing

p3 Produce q3 at a profit

p1 Produce q’’ at a loss

q3

Cost and demand for a competitive firm

8

Price, Cost

In the short run, the optimal quantity equates the marginal cost to the given price, provided that this price exceeds the average variable cost. Thus, at a price of p1, the firm produces a quantity of q” but at a price of p’1 the firm produces nothing

MC ATC

AVC

Quantity 0

e

bp3 p3=MR3=AR3

q3

a

p1 p1=MR1=AR1

d

q”q’

q’+1

q’0

p2 p2=MR2=AR2

p0 p0=MR0=AR0

q0

p’0 p’0=MR’0=AR’0c

A Competitive Firm’s Supply• Supply function

• How much of a good• One firm - willing to sell• Given any market price• Other factors constant

• Supply function• Marginal cost curve• Above - lowest point on AVC curve

9

A short-run supply curve for a competitive firm

10

Price, Cost

At prices below p0, the firm produces nothing because these prices are less than the average variable cost. At prices above p0, the supply curve is identical to the marginal cost curve

Quantity 0

P0

Shut down price

q0

S

Competitive Markets in the Short Run• Market supply function (aggregate supply function)

• How much of a good• All of firms supply• Any given market price

• Horizontally add supply curves• All of firms in the industry

• Aggregate short-run marginal cost• Supply each unit

11

Market Supply

12

The market supply curve is the horizontal sum of the marginal cost curves of all of the firms in the industry

Quantity

0

Price

p1

p2

p3

p4

p’2

FIRM 1

Quantity

0

PriceFIRM 2

Quantity

0

PriceFIRM 3

Quantity

0

PriceMARKET SUPPLY

q11 q1

2’ q14 q2

2’ q24 q3

4 q11 q1

4+q24+q3

4q12’ +q2

2’

A

B

Competitive Markets in the Short Run• Short-run equilibrium

• Price-quantity combination• Prevail - perfectly competitive market• Short run

• (1) Firms – no change (quantity supplied)• (2) Consumers – no change (quantity demanded)• (3) Aggregate supply = Aggregate demand

13

Equilibrium

14

Price

The equilibrium price of pe and quantity of qe equate the aggregate supply and aggregate demand in the market.

Quantity 0

Market Supply

Market Demand

pe

p1

p2

q2s q2

dq1d q1

sqe

The SR equilibrium in competitive market

15

The short-run equilibrium for a competitive industry is consistent with positive profits.

PriceFIRM 1

PriceFIRM 2

PriceFIRM 3

Quantity

0

Price

Quantity

0

Quantity

0

Quantity

0

MC MC MC

q1e

ATC

π1

ATC

q2e

π2

ATC

q3e qe=q1

e+q2e+q3

e

S

D

pepe

Policy Analysis in the Short Run• Comparative static analysis

• Examine market equilibrium• Before and after policy change• Effect on market price and quantity

• Compare 2 static equilibria

16

The market for illegal drugs

17

Price

An increase in the probability that a drug dealer will be caught shifts the supply curve to the left, from S1 to S2, raises the equilibrium price from pa to pb, and lowers the equilibrium quantity from qa to qb.

Quantity 0

D

S1

qa

paa

S2

qb

pb

b

The decision about whom to prosecute

18

PriceA policy of prosecutingillegal drug dealersshifts the supply curvefrom S1 to S2 and theequilibrium from point ato point c.

Quantity 0

D1

S1

qa

paa

S2

qc

pc

c

A policy ofprosecuting illegal drugusers shifts the demandcurve from D1 to D2 andthe equilibrium frompoint a to point b.

D2

b

qb

pb

The incidence of a tax and elasticity of demand

19

When demand is perfectly inelastic, the incidence of a tax of α per unit falls entirely on the consumer

Price

Quantity 0 Quantity 0Quantity 0

Price Price

S1

S2

qa

D

(a) (b) (c)

a

b

pa

pa+α

αS1S2

Dpa

When demand is perfectly elastic, the incidence of the tax falls entirely on the producer

S1

D

S2

a

b

pa

qa

pb

qb

c

d

When elasticity is intermediate between 0 and -∞, the incidence of the tax falls partly on the consumer and partly on the producer

The labor market and the minimum wage

20

Price

The establishment of a minimum wage of wmin raises the equilibrium wage paid to employed workers from wa to wmin and lowers the number of employed workers from qa to qmin .

Quantity 0

D1

S1

qa

wa a

wmin

qmin

Government-subsidized wages

21

Price

A government subsidy of the wages of teenage workers shifts the demand curve for labor from D1 to D2, raises the equilibrium wage from wa to wb, and raises the number of workers employed from qa to qb.

Quantity 0

D1

S1

D2D3

wa

qa

wb

qb

Figure 14.11• Subsidizing youth employment

22

Wage

A subsidy leads to higher wages and more young employees

Labor 0

D

S

b

D’

qaqmin

wmin

wa

a

e

cd

wv