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Chapter 22
Perfect Competition
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-1
22-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• The characteristics of perfect competition
• The perfect competitor’s demand curve
• The short run and and the long run
• Economic and accounting profits
• Decreasing, constant, and increasing cost industries
22-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Perfect Competition
• Is the first of four competitive modes• It is a theoretical model that does not exist in
the real world• This will serve as the standard by which we will
measure the next three competitive models– Monopoly
– Monopolistic Competition
– Oligopoly
Definition of Perfect Competition
• There are so many firms that no one firm is large enough to influence price– Either by withholding output from the
market or by increasing its output
• The firms are selling an identical product– A product is identical, in the minds of the
buyers, if they have no reason to prefer one seller over another
22-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Definition of Perfect Competition
• The market has perfect mobility– No barriers to entry such as licenses, long-
term contracts, government franchises, patents, control over vital resources, etc.
– One possible exception is money
• Perfect knowledge about the market exist– Everyone knows about every possible
economic opportunity
22-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
22-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor’s Demand Curve
Output
Firm
Output (in millions)
Industry
D,MR
D
S
5
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
10 15 20 25 30 1 2 3 4 5 6 7
The intersection of the industry supply and demand curve set the price that is taken by the individual firm, in this case $6
22-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor’s Demand Curve
Output
Firm
Output (in millions)
Industry
D,MR
D
S
5
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
10 15 20 25 30 1 2 3 4 5 6 7
The perfect competitor faces a horizontal , or perfectly elastic, demand curve
A firm with a perfectly elastic demand curve has an identical MR curve (MR=P)
22-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor’s Demand Curve
Output
Firm
Output (in millions)
Industry
D,MR
D
S
5
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
10 15 20 25 30 1 2 3 4 5 6 7
The perfect competitor has to take the market price (it is a price taker!)
22-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor’s Demand Curve
Output
Firm
Output (in millions)
Industry
D,MR
D
S
5
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
10 15 20 25 30 1 2 3 4 5 6 7
Why is the individual firm’s demand curve flat instead of sloping down to the right?
The individual firm’s output is between 0 & 30 units. The industry’s output in the millions. It is impossible for the individual firm to increase output enough to change the price even one cent. Theoretically, the individual firm’s demand curve slopes down and to the right ever so slightly. But we can’t see the slope, so we draw it horizontally and consider it perfectly elastic
30/4,000,000 = .0000075
7510,000,000
22-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
20
18
16
14
12
10
8
6
4
2
0
D,MR
ATC
MC
0 2 4 6 8 10 12 14 16 18 20
The Perfect Competitor in the Short Run
In the short run the perfect competitor may make a profit or lose money
22-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
20
18
16
14
12
10
8
6
4
2
0
D,MR
ATC
MC
0 2 4 6 8 10 12 14 16 18 20
The Perfect Competitor in the Short Run
Is this firm making a profit or losing money?Answer: Losing money because the D,MR curve is below the ATC curve
22-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
20
18
16
14
12
10
8
6
4
2
0
D,MR
ATC
MC
0 2 4 6 8 10 12 14 16 18 20
The Perfect Competitor in the Short Run
How much money is this firm losing?
Price = $6
ATC = $8.50
Output = $8
TP = ( P – ATC) X OutputTP = ($6 - $8.50) X 8TP = -$2.50 X 8TP = - $20
22-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Short Run
Output
20
18
16
14
12
10
8
6
4
2
0
D,MRATC
MC
0 2 4 6 8 10 12 14 16 18 20
Is this firm making a profit or losing money?Answer: Making a profit because the D,MR curve is above the ATC curve
22-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Short Run
Output
20
18
16
14
12
10
8
6
4
2
0
D,MRATC
MC
0 2 4 6 8 10 12 14 16 18 20
Output = $11
ATC = $8.10
Price = $10
TP = ( P – ATC) X OutputTP = ($10 - $8.10) X 11TP = $1.90 X 11TP = $20.90
22-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Long Run
Output
D,MR
ATC
MC
Firm
D
S
Market20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
0
Output (in millions)
0 1 2 30 2 4 6 8 10 12 14 16 18 20
In the long run the perfect competitor breaks even
Since the ATC curve lives above the demand curve, the firm is losing money at a price of $6. How do we then get to the long run where the firm is breaking even?
22-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
Going from Taking a Loss in the Short Run to Breaking Even in the Long Run
At a price of $6 the firm is losing money and so, too, are all the other firms in the industry
22-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
Going from Taking a Loss in the Short Run to Breaking Even in the Long Run
Some firms leave the industry in the long run pushing the supply down from S1 to S2
22-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
Going from Taking a Loss in the Short Run to Breaking Even in the Long Run
This pushes the industry price up to $8. At this price the firm breaks even.
22-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Going from Making a Profit in the Short Run to Breaking Even in the Long Run
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
At a price of $10 all firms in the industry are making a profit
22-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Going from Making a Profit in the Short Run to Breaking Even in the Long Run
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
New firms are attracted into the industry. This increases supply moving the supply curve from S1 to S2
22-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Going from Making a Profit in the Short Run to Breaking Even in the Long Run
Output
D2,MR2
ATC
MC
Firm
Output (in millions)
D
S2
Market
D1,MR1
S1
20
18
16
14
12
10
8
6
4
2
0
20
18
16
14
12
10
8
6
4
2
00 2 10 2 34 6 8 10 12 14 16 18 20
This reduces the industry price to $8, at which the firms break even
22-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Long Run
Output
24
23
22
21
20
19
18
17
16
15
D,MR
ATC
MC
5 10 15 20
In the long run the firm breaks evenThe ATC curve is tangent to the demand curve at the point where MC = MR.
ATC will equal price at the break-even point (the minimum point on the ATC curve)
Price = ATC
The most profitable level of output is 11.1
22-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Long Run
Output
24
23
22
21
20
19
18
17
16
15
D,MR
ATC
MC
5 10 15 20
Price = ATC
The most profitable level of output is 11.1
A firm operates at peak efficiency when it produces at the minimum point of its ATC. For the perfect competitor in the long run, the most profitable output is at the minimum point of its ATC because this is also where MC=MR
Efficiency• A firm operates at peak efficiency when it
produces at the lowest possible cost– That would be the minimum point of its ATC curve
( the break-even point)
• For the perfect competitor in the long run, the most profitable output is at the minimum point of is ATC curve because this will be where MC=MR
• Because of the degree of competition, the perfect competitor is forced to operate at peak efficiency– Other forms of competition do not force firms to
operate at peak efficiency
22-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits
22-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
• Accounting profits are what is left over from sales (revenue) after a firm has paid all of its explicit cost– Explicit cost is the cost of doing business
• rent, wages, cost of goods sold, fuel, taxes, etc.
Sales $200,000
- Explicit cost 115,000
Accounting Profit 85,000
Economic and Accounting Profits
22-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting profit $ 85,000
- Explicit cost 85,000
Economic Profit 0
• Economic profits are what is left over from accounting profits after a firm has subtracted its implicit cost– Implicit cost are a firm’s opportunity cost
• the opportunity cost of any choice is the forgone value of the next best alternative
Suppose you have invested $100,000 of your own money in your business. You could have earned $15,000 interest on this money. Instead of you and your spouse working 12 hours a day , seven days a week, you both could have earned $70,000 working for some one else. ($15,000 + $70,000 = $85,000 implicit cost)
• Why stay in business if your economic profits are zero?– You are still making accounting profits– You wouldn’t do any better if you invested
your money elsewhere and worked for someone else
– You are your own boss by having your own business
22-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits
22-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits
• When economic profits become negative, particularly if those losses are substantial and appear they may be permanent, more and more people will close their business– They will go to work for some one else– They will go into a different business
• Market supply decreases and forces prices up– This process continues until people stop getting out
22-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits• When economic profits become negative,
particularly if those losses are substantial and appear they may be permanent, more and more people will close their business– They will go to work for some one else
– They will go into a different business
• Market supply decreases and forces prices up– This process continues until people stop getting out
S1
S2
P2
P1
22-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits• When there are economic profits (short run)
more people are attracted into this type of business
• Market supply increases and forces prices down– This process continues until people stop getting in
– Economic profits are zero at this point (long run)
– No one else wants to enter or leave
22-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic and Accounting Profits• When there are economic profits (short run)
more people are attracted into this type of business
• Market supply increases and forces prices down– This process continues until people stop getting in
– Economic profits are zero at this point (long run)
– No one else wants to enter or leaveS2
S1
P2
P1
22-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Decreasing, Constant, and Increasing Cost Industries
Output (in thousands)
200
180
160
140
120
100
80
60
40
20
0
Decreasing costs Increasing costs
Constant costs
ATC
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
Decreasing cost industries are characterized by firms operating on the declining segments of their ATC curves
They can take advantage of economies of scale (discounts for buying larger quantities, declining AFC as output expands, lower cost from specialization, etc.)
22-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Decreasing, Constant, and Increasing Cost Industries
Output (in thousands)
200
180
160
140
120
100
80
60
40
20
0
Decreasing costs Increasing costs
Constant costs
ATC
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
Constant cost industries are where ATC does not change as output expands
Economies of scale & diseconomies of scale are in balance (improvements in technology can help keep cost declining as output expands; improvements in production processes can increase quality and lower cost at the same time)
22-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Decreasing, Constant, and Increasing Cost Industries
Output (in thousands)
200
180
160
140
120
100
80
60
40
20
0
Decreasing costs Increasing costs
Constant costs
ATC
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
Increasing cost industries are where diseconomies of scale overwhelm economies of scale.Examples of diseconomies of scale are managerial inefficiencies (the cost of maintaining a huge bureaucracy, increased difficulties of communication, duplication and waste, etc.)
22-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Decreasing, Constant, and Increasing Cost Industries
Output (in thousands)
200
180
160
140
120
100
80
60
40
20
0
Decreasing costs Increasing costs
Constant costs
ATC
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
Factor cost - wages, rent, and interest - are by far the most important determinants of whether cost are falling, constant, or increasingUsually, factor cost will eventually rise, which ultimately makes every industry an increasing cost industry (but the range of output within which they often operate is one of decreasing or constant cost)
2 2 -3 6C o p y r ig h t 2 0 0 2 b y T h e M c G r a w -H ill C o m p a n ie s , In c . A ll r ig h ts r e se r v e d .
T h e P e r fe c t C o m p e tito r ’s D e m a n d C u r v e
Output
Firm
Output (in millions)
Industry
D,M R
D
S
5
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
1 0 1 5 2 0 2 5 3 0 1 2 3 4 5 6 7
3 0 /4 ,0 0 0 ,0 0 0 = .0 0 0 0 0 7 5
7 51 0 ,0 0 0 ,0 0 0
T h e in d iv id u a l f ir m ’s o u tp u t is b e tw e e n 0 & 3 0 u n its . T h e in d u str y ’s o u tp u t is in th e m illio n s . T h is f ir m w o u ld h a v e to g r o w a n d ex p a n d o u tp u t to b e t w e e n 8 0 ,0 0 0 u n its a n d 1 5 0 ,0 0 0 u n its to h a v e a n y in f lu e n c e o n p r ic e . O n c e it d id , p e r fe c t c o m p e tit io n w o u ld n o lo n g e r e x is t in th is in d u s try
