Chapter 8 perfect competitio-micro

Chapter 8Chapter 8

Perfect CompetitionPerfect Competition

Perfect CompetitionPerfect Competition

• What is a market structure anyways?– Def: A market structure describes the key traits of

a market, including the number of firms, the similarity of the products they sell, and the ease of entry into and exit from the market.

– The most competitive of the market structures is “perfect competition.”

http://www.youtube.com/watch?v=9Hxy-TuX9fs&feature=related




Characteristics of Perfect CompetitionCharacteristics of Perfect Competition

• Three Characteristics:– Many buyers and sellers– A standardized (or homogenous) product– Buyers and sellers are fully informed about the

price and availability of all resources and products– Firms and resources are freely mobile- easy entry

or exit from the market• No patents, licenses, and no high capital costs.

What do these characteristics mean?What do these characteristics mean?

• If these conditions exist in a market, an individual buyer or seller has no control over the price.

• Price is determined by market demand and supply.– Once the market establishes price, then a firm is free

to supply whatever quantity that maximizes profit.– A perfectly competitive firm is so small relative to the

market that the firm’s supply decision does not affect the market price.

Does Perfect Competition Really Exist in the Real-World?

• Examples of Perfectly Competitive Markets.– Agricultural products- wheat, corn, livestock– In the U.S., 75,000 farmers raise hogs, and tens of

millions of U.S. households buy pork products

Why is Perfect Competition Important

• The model of perfect competition allows us to make a number of predictions that hold up pretty well when compared to the real world.

• It is also an important benchmark for evaluating the efficiency of other types of markets.

Demand Under Perfect Competition

• Market price– Where supply and demand are equal

• Demand curve for one supplier– Horizontal– Perfectly elastic

• Price taker

The Perfectly Competitive Firm as Price Taker

• Def: A price taker is a seller that has no control over the price of the product it sells.– What does it mean to be a price taker?– Take it or leave it

Market Equilibrium and a Firm’s Demand Curve in Perfect Competition

Pric

e pe

r bu

shel

$5

D

S

(a) Market equilibrium

Pric

e pe

r bu

shel

$5 d

(b) Firm’s demand

1,200,000 Bushels of

wheat per day0 15 Bushels of

wheat per day0 5 10

Market price ($5)- 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 - horizontal at the market price.

Short-Run Profit Maximization for a Short-Run Profit Maximization for a Perfectly Competitive FirmPerfectly Competitive Firm

• We now know that the perfectly competitive (PC) firm has no control over price. So, what can it control? How can it make a profit?– The PC firm makes ONE decision- What quantity of

output to produce that maximizes profit? How much should I produce to earn the most profit?

– Two methods of finding this profit• TR-TC, where TC includes implicit and explicit costs.• MR=MC

The Total Revenue (TR)- Total Costs (TC) Method

• Using the total revenue - total cost method, where should a firm produce?– Where the distance between TR and TC is the

greatest (i.e. where profit is the greatest)

EXAMPLE OF FINDING PROFITEXAMPLE OF FINDING PROFIT

The Marginal Revenue Equals Marginal The Marginal Revenue Equals Marginal Cost MethodCost Method

• Remember that the Marginal Cost is the change in total cost as the output level changes one unit.

• So, now we need to introduce marginal revenue (MR), this concept is very similar to marginal cost. – Def: Marginal revenue is the change in total revenue

from the sale of one additional unit

outputinchange

TRinchangeMR

Short-Run Cost and Revenue for a Perfectly Competitive Firm

Short-Run Profit Maximization

(a) Total revenue minus

total cost

(b) Marginal cost equals

marginal revenue

TR: straight line, slope=5=P

TC increases with output

Max Economic profit:

where TR exceeds TC by

the greatest amount

MR: horizontal line at P=$5


at 12 bushels,

where MR=MC

Total cost Total revenue

(=$5 × q)

Tot

al d

olla

rs $60

48

15

Bushels of wheat per day0 5 7 10 12 15

Dol

lars

per

bus

hel

$5

4


Average total cost

d = Marginal revenue

= Average revenue

Marginal cost

Maximum economic

profit = $12

a

e

Profit

Important Points

• Remember that the demand curve for a perfectly competitive firm is horizontal.

• In a perfectly competitive firm, P=MR• MC curve will have a J-Shaped curve• The firm maximizes profit by producing the

output where marginal revenue equals marginal cost (MR=MC).

MR=MC Method

• Why should a firm continue to produce as long as MR > MC?

• Why should a firm continue to produce as long as MR < MC?

Why does P=AR=MR=Demand CurveWhy does P=AR=MR=Demand Curve

• P=AR(average revenue)• P=MR

Short-Run Profit Maximization


total cost


marginal revenue

TR: straight line, slope=5=P

TC increases with output


where TR exceeds TC by

the greatest amount

MR: horizontal line at P=$5


at 12 bushels,

where MR=MC


(=$5 × q)

Tot

al d

olla

rs $60

48

15


Dol

lars

per

bus

hel

$5

4


Average total cost


= Average revenue

Marginal cost

Maximum economic

profit = $12

a

e

Profit

A Perfectly Competitive Firm Facing a Short-Run Losses

If market conditions cause the price to fall, then the firm could experience losses in the short-run.

When this occurs, then there is NO level of output that the firm could produce to earn a profit

What should they do?Firms will continue to operate at these losses for a

short-time. They will operate at this loss when the price is high

enough to cover average variable cost, but not average total cost.

Example of Minimizing LossesExample of Minimizing Losses

Minimizing Short-Run Losses

Short-Run Loss Minimization


total cost

TC>TR; loss

Minimize loss: 10 bushels


marginal revenue

MR=MC=$3; ATC=$4

P=$3; P>AVC

Continue to produce

in short run


(=$3 × q)

Tot

al d

olla

rs

$4030

15

Bushels of wheat per day0 5 10 15

Average total cost


= Average revenue

Marginal cost

Minimum economic

loss = $10

eLoss

Bushels of wheat per day0 5 10 15

Dol

lars

per

bus

hel

$4.00

3.002.50

Average variable cost

A Perfectly Competitive Firm Facing A Perfectly Competitive Firm Facing Shut-DownShut-Down

• What if the price drops below AVC? – If the price drops below AVC then the firm will

shut-down.– The firm is better off to shut-down and produce

no output.

Example of Shut-DownExample of Shut-Down

http://www.youtube.com/watch?v=61GCogalzVc



The Perfectly Competitive Firm’s Short-Run Supply Curve

• We are going to now develop the S-R supply curve for the individual firm.

• The perfectly competitive firms’ S-R supply curve is its marginal cost curve above the minimum point on its average variable cost curve.

• Why is it above the AVC curve?

Summary of 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

Dol

lars

per

uni

t

Shutdown

point

Break-even

point

p5>ATC, q5, economic profit

p2=AVC, q2 or 0, loss=FC

ATC>p3>AVC, q3, loss <FC

p1<AVC, shut down,

q1=0,loss=FC

p4=ATC, q4, normal profit

Firm’s short-run S curve

The Perfectly Competitive Industry’s S-R Supply Curve

• Now, we are going to derive the industry’s S-R supply curve.– The perfectly competitive industry’s S-R supply

curve is the horizontal summation of the MC curves of all firms in the industry above the minimum point of each firm’s AVC curve.

Aggregating Individual Supply to Form Market Supply

10 20Quantity

per period

0

p

p’

Pric

e pe

r un

it SA

(a) Firm A

10 20Quantity

per period

0

p

p’

SB

(b) Firm B

10 20Quantity

per period

0

p

p’

SC

(c) Firm C

30 60Quantity per period

0

p

p’

SA + SB + SC = S

(d) Industry, or market, supply

Short-Run Profit Maximization and Market Equilibrium

S = horizontal sum of the supply curves of all firms in the industry Intersection of S and D: market price $5

Market price $5 determines the perfectly elastic demand curve (and MR) facing the individual firm.

L-R Equilibrium for a Perfectly Competitive Firm

• In the L-R, all inputs are variable.• If there are economic profits, then new firms

enter, shifting the S-R industry supply curve to the right, causing price to fall until the profits are zero.

• But if there are economic losses, existing firms leave, shifting the S-R industry supply curve to the left, and prices rise to the point where economic profit is zero.

L-R Conclusions

• P=MR=SRMC=SRATC=LRAC• If these variables do not change, then the

firms have no reason to change output levels.

(a) Firm

d

(b) Industry or market

QQuantity

per period0q

Quantity

per period0

MC

ATC

Dol

lars

per

uni

t

p

Pric

e pe

r un

it

p

S

D

LRAC

Long run equilibrium: P=MC=MR=ATC=LRAC. 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

Long-Run Equilibrium for a Firm and the Industry

Example of Long-Run Adjustment to a Change in Demand

Example of Long-Run Adjustment to a Change in Demand

Long-Run Adjustment to an Increase in Demand

Long run: new firms enter the industry; supply increases to S’; price drops back to p; firm’s demand drops back to d.

Increase in D to D’ moves the market equilibrium point from a to b; firm’s demand increases to d’; economic profit in short run.

(a) Firm

d

(b) Industry or market

MC

ATC

S

D

LRAC

D’

a

b

Pric

e pe

r un

it

p

p’

Qa

Quantity

per period0 Qb Qc

Dol

lars

per

uni

t

p

p’ d’

qQuantity

per period0 q’

Profit

S’

c S*

The Long-Run Industry Supply Curve

• The long-run industry supply curve shows the relationship between price and quantity supplied once firms fully adjust to any short-term economic profit of loss resulting from a change in demand.

Constant-Cost Industries• Each firm’s long-run average cost curve does not

shift up or down as industry output changes.• Each firm’s per-unit costs are independent of the

number of firms in the industry.• Thus, the long-run supply curve for a constant-

cost industry is horizontal.• It uses such a small portion of the resources

available that increasing output does not bid up resource prices.– Example: Pencil Market

Increasing-Cost Industries

• This occurs when the expanding output bids up the prices of resources or otherwise increases per-unit production costs, and these higher costs shift up each firm’s cost curves.

• Example– The expansion of oil production could bid up the

prices of drilling rigs.

An Increasing-Cost Industry

D increases to D’, new short-run equilibrium: point b. Higher price pb; firm’s demand curve shifts up (db); economic profit, which attracts new firms.Input prices go up, MC and ATC curves shift up.Market S increases to S’; new price pc, firm’s demand curve shifts down to dc; normal profit.

Perfect Competition and Efficiency

7

Productive efficiency: Making Stuff Right Produce output at the least possible cost

Min point on LRAC curveP = min average cost in long run

Allocative efficiency: Making the Right StuffProduce output that consumers value most

Marginal benefit = P = Marginal costAllocative efficient market

What’s So Perfect About Perfect Competition?

Consumer surplus Consumers pay less price than they are willing to

pay (along Demand curve) Producer surplus

Producers are willing to accept less (along Supply curve; MC) than what they are receiving (the market price)

Gains from voluntary exchange Consumer and producer surplus Productive and allocative efficiency Maximum social welfare

The overall well-being of people in the economy.

The surplus (or bonus) from the market exchange that the sellers and buyers receive.

LO7

Consumer Surplus and Producer Surplus for a Competitive Market

0 100,000120,000

200,000Quantity

per period

$10

65

Dol

lars

per

uni

t

S

D

e

m

Consumer

surplus

Producer

surplus

Consumer surplus: area above the

market-clearing price ($10) and

below the demand.

Producer surplus: area above the

short-run market supply curve and

below the market-clearing price

At p=$5: no producer surplus; the

price just covers each firms AVC.

At p=$6: producer surplus is the area between $5, $6, and S curve.

Exhibit 13

Documents

Chapter 8 perfect competitio-micro