Chapter 14Perfect Competition

The Meaning of Competition A perfectly competitive market has

the following characteristics:– Many buyers and sellers– Homogenous good– Free entry and exit

The Meaning of Competition As a result of its characteristics, the

perfectly competitive market has the following outcomes:– The actions of any single buyer or seller

in the market have a negligible impact on the market price.

– Each buyer and seller takes the market price as given.

The Competitive Firm’s supply

The goal of a competitive firm is to maximize profit.

This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

The Revenue of a Competitive Firm

Average revenue is how much revenue a firm receives for the typical unit sold. In a perfect competitive market average revenue equals the price of the good.A v erag e R e ven u e = T o ta l rev en u e

Q uan tity

P rice Q uan tityQ uan tity

P rice

The Revenue of a Competitive Firm

Marginal revenue is the change in total revenue from an additional unit sold.

MR =TR/Q For competitive firms, marginal

revenue equals the price of the good.

Total, Average, and Marginal Revenue for a Competitive

Firm

Profit Maximization

Profit Maximization

Quantity0

Costsand

Revenue

TR

TR 1

Q 1

If the firm produces Q1, profit is maximized.

If the firm produces Q2, profit=0.

TC 1

TC

Q2

Profit Maximization: MR=MC

Profit maximization occurs at the quantity where marginal revenue equals marginal cost.– When MR > MC, increasing Q raises

profit– When MR < MC, decreasing Q raises

profit– When MR = MC, profit is maximized.

Profit Maximization

Quantity0

Costsand

RevenueMC

ATC

AVC

MC1

Q1

MC2

Q2

The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P = MR1 = MR2 P = AR = MR

If the firm produces Q1, marginal cost is MC1.

If the firm produces Q2, marginal cost is MC2.

Suppose the market price is P.

Marginal Cost as the Supply Curve

Quantity0

Price

MC

ATC

AVCP1

Q1

P2

Q2

So, this section of thefirm’s MC curve isalso the firm’s supplycurve.

As P increases, the firm will select its level of output along the MC curve.

Firm making losses: not shut down

Quantity0

Costsand

Revenue

TR

TC 1

Q 1

The firm realizes minimum losses at Q1.

Total cost is always higher than total revenue.

TR 1

TC

MR=MC gives the optimum production point

Firm realizing losses: shut down

Quantity0

Costsand

Revenue

TR

TC 1

Q 1

The loss at MR=MC is not the minimum.

TR 1

TCMR=MC does not always give the optimum production point

Is MR=MC enough? MR=MC gives the optimum output

level, if the firm is to produce any output level greater than zero.

Sometimes a firm makes losses at the quantity where MR=MC.

The question then is:– Should the firm stay in business or shut

down?

The Shut down DecisionShould a firm continue to produce

when it is realizing losses? A shutdown refers to a short-run

decision not to produce anything during a specific period of time because of current market conditions.

Exit refers to a long-run decision to leave the market.

More Formally, Fixed costs are sunk costs The firm shuts down if the revenue is

less than the variable cost of production.

Shut down if : – Profit if in business <Profit if shut down

TR-VC-FC < 0-FCTR<VC

Divide both sides by Q:TR/Q < VC/Q

Shut down if P < AVC

Short-Run Supply Curve

Quantity

AVC

0

Costs

If P > AVC, firm will continue to produce in the short run.

P

Short-Run Supply Curve

Quantity

AVC

0

Costs

If P < AVC, firm will shut down.

P

Short-Run Supply CurveMC

Quantity

ATC

AVC

0

Costs

Firmshutsdown ifP< AVC

Firm’s short-runsupply curve

If P > AVC, firm will continue to produce in the short run.

If P > ATC, the firm will continue to produce at a profit.

The Firm’s Short-Run Decision to Shut Down

The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.

Summary To find the profit maximizing

quantity:– Compare P and MC

To check shut down– Compare P and AVC

Long-Run Decision to Exit or Enter a Market

In the long run, the firm exits if the revenue it would get from producing is less than its total cost, i.e. if– Profit in business <Profit if exit

TR-TC < 0 TR<TC

Divide both sides by Q: TR/Q < TC/Q

Exit if P < ATC

Long-Run Supply Curve

MC = long-run S

Firmexits ifP < ATC

Quantity

ATC

0

CostsFirm’s long-runsupply curve

Firmenters ifP > ATC

Summary: The Supply Curve

Short-Run Supply Curve– The portion of its marginal cost curve

that lies above average variable cost. Long-Run Supply Curve

– The marginal cost curve above the minimum point of its average total cost curve.

Short-Run Market Supply(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Market Supply

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000

If the industry has 1000 identical firms, then at each market price, industry output will be 1000 times larger than the representative firm’s output.

The Long Run and Firm Profit

When a perfect competitive industry realizes profit , entry by new firms occurs.

When a perfect competitive industry realizes losses, firms within the industry exit the market.

Firms will enter or exit the market until profits are driven to zero.

In the long run, price equals the minimum of average total cost.

Positive profit creates entry(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ATCMC

P

Q(profit-maximizing quantity)

Profit

RevenueTotal Cost

Negative profit creates exit(b) A Firm with Losses

Quantity0

Price

ATCMC

(loss-minimizing quantity)

P = AR = MRP

ATC

Q

Loss

Long Run Equilibrium The conditions characterizing the

long run equilibrium P and Q: – The total quantity demanded equals the

total quantity suppliedQuantity Demanded=Quantity Supplied

– Each firm maximizes profit.Price=Marginal cost

– No entry or Exit, i.e., zero profitPrice=Average total cost

Long-Run Market Supply

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply

Quantity (market)

Price

0

MC

ATC

D

S

q Q

P*

Describe the Long Run Equilibrium

firms that remain must be making zero economic profit.

Firms produce at the lowest possible unit cost, i.e. firms are operating at their efficient scale.

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

MC

ATC

P*

Q*

Why Do Competitive Firms Stay in Business If they

Make Zero Profit? In the zero-profit equilibrium, the

firm’s revenue compensates the owners for the time and money they expend to keep the business going.

Total cost includes all the opportunity costs of the firm.

Comparative Statics: A Shift in Demand in the Short Run

and Long Run An increase in demand raises price

and quantity in the short run. Firms earn profits because price now

exceeds average total cost.

An Increase in Demand in the Short Run and Long Run

Firm(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

P1

1Q

A

MC

A market begins in long run equilibrium.

And firms earn zero profit.

An Increase in Demand in the Short Run and Long Run

Market Firm(b) Short-Run Response

Quantity (firm)0

Price

P1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P2

Q1

A

Q2

P2B

ATCMC

An increase in market demand……raises price and output.

The higher P encourages firms to produce more… …and generates short-run profit.

An Increase in Demand in the Short Run and Long Run

P1

Firm(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

B

D1

D2

S1

AS2

Q3

C

Profits induce entry and market supply increases.

The increase in supply lowers market price. In the long run market price is restored, but market supply is greater.

Quantity0

P

MC

Firm

Quantity (firm)0

PriceMarket

Quantity (market)

Price

0

D

SMC