Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 7 PERFECT COMPETITION Part Two: Microeconomics of Product Markets

Slides prepared by Dr. Amy Peng, Ryerson University

CHAPTER 7CHAPTER 7PERFECT PERFECT

COMPETITIONCOMPETITION

Part Two: Microeconomics Part Two: Microeconomics of Product Marketsof Product Markets

©2007 McGraw-Hill Ryerson Ltd.

Chapter 7 2

In this chapter you will learn:In this chapter you will learn:

7.1 The four basic market structures 7.2 The conditions required for perfectly

competitive markets7.3 How firms in perfect competition

maximize profits or minimize losses7.4 Why the marginal cost curve and

supply curve of competitive firms are the same

7.5 About the firm’s profit maximization in the long run

7.6 About the efficiency of competitive markets


Chapter 7.1 3

Four Market StructuresFour Market Structures

• Perfect Competition• Monopoly• Monopolistic Competition• Oligopoly

OligopolyOligopoly

Market Structure ContinuumMarket Structure Continuum

PurePureCompetitionCompetition

PurePureMonopolyMonopoly

MonopolisticMonopolisticCompetitionCompetition


Chapter 7.2 4

Market Structure ContinuumMarket Structure Continuum

PurePureCompetitionCompetition

PurePureMonopolyMonopoly

MonopolisticMonopolisticCompetitionCompetition OligopolyOligopoly

Characteristics of Perfect Characteristics of Perfect CompetitionCompetition

• Very Large Numbers• Standardized Product• Price-Takers• Easy Entry and Exit


Chapter 7.2 5

Demand for a Firm in Perfect Demand for a Firm in Perfect CompetitionCompetition

• Perfectly Elastic Demand• Average, Total, and Marginal

Revenue– average revenue = price– marginal revenue = price– total revenue = price x quantity

Illustrated…Illustrated…


Chapter 7.2 6

Product price, P

(average revenue)

Quantity demanded,

Q

Total Revenue,

TR

Marginal Revenue,

MR

131 0 0

131 1 131

131 2 262

131 3 393

131 4 524

131 5 655

131 6 786

131 7 917

131 8 1048

131 9 1179

131 10 1310

Product price, P

(average revenue)

Quantity demanded,

Q

Total Revenue,

TR

Marginal Revenue,

MR

131 0

131 1

131 2

131 3

131 4

131 5

131 6

131 7

131 8

131 9

131 10

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131

]] 131131


Chapter 7.2 7

Figure 7-1 The Demand and Revenue Figure 7-1 The Demand and Revenue Curves Curves

for a Firm in Perfect Competitionfor a Firm in Perfect Competition

D = MR = AR

TR

1179

1048

917

786

655

524

393

262

131

0Quantity Demanded

2 4 6 8 10 12

Pri

ce a

nd r

evenu

e

Demand is perfectly elastic since the firm can sell as much output as it wants at the market price


Chapter 7.3 8

Profit Maximization in the Short Profit Maximization in the Short RunRun

• Purely competitive firm can maximize its profit (minimize its loss) only by adjusting output

Two Approaches:• total revenue-total cost

approach• marginal revenue-marginal cost

approach


Chapter 7.3 9

Q TFC TVC TC TRProfit or

Loss

0

1

2

3

4

5

6

7

8

9

10


Loss

0 $100

1 100

2 100

3 100

4 100

5 100

6 100

7 100

8 100

9 100

10 100


Loss

0 $100 $ 0

1 100 90

2 100 170

3 100 240

4 100 300

5 100 370

6 100 450

7 100 540

8 100 650

9 100 780

10 100 930


Loss

0 $100 $ 0 $ 100

1 100 90 190

2 100 170 270

3 100 240 340

4 100 300 400

5 100 370 470

6 100 450 550

7 100 540 640

8 100 650 750

9 100 780 880

10 100 930 1030


Loss

0 $100 $ 0 $ 100 $ 0

1 100 90 190 131

2 100 170 270 262

3 100 240 340 393

4 100 300 400 524

5 100 370 470 655

6 100 450 550 786

7 100 540 640 917

8 100 650 750 1048

9 100 780 880 1179

10 100 930 1030 1310


Loss

0 $100 $ 0 $ 100 $ 0 $-100

1 100 90 190 131 - 59

2 100 170 270 262 - 8

3 100 240 340 393 + 53

4 100 300 400 524 +124

5 100 370 470 655 +185

6 100 450 550 786 +236

7 100 540 640 917 +277

8 100 650 750 1048 +298

9 100 780 880 1179 +299

10 100 930 1030 1310 +280

p=$131p=$131p=$131p=$131


Chapter 7.3 10

Profit Maximization, Pure Competition

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

0 2 4 6 8 10 12 14

Quantity

$

TCTCTRTRTRTRMaximum Maximum economic profit economic profit

$299$299

Maximum Maximum economic profit economic profit

$299$299

Break-even point (normal Break-even point (normal profit)profit)

Break-even point (normal Break-even point (normal profit)profit)

Break-even pointBreak-even pointBreak-even pointBreak-even point

Figure 7-2Figure 7-2


Chapter 7.3 11

Total Revenue-Total Cost Total Revenue-Total Cost ApproachApproach

• Profit = TR - TC• Profit is maximized where the

vertical distance between TR and TC is maximized

• Break-even points are where TR=TC

• Now, the marginal revenue-marginal cost approach…


Chapter 7.3 12

Q TFC TVC TC

0 $100 $ 0 $ 100

1 100 90 190

2 100 170 270

3 100 240 340

4 100 300 400

5 100 370 470

6 100 450 550

7 100 540 640

8 100 650 750

9 100 780 880

10 100 930 1030

MC

$ 90

80

70

60

80

90

110

130

150

]]]]]]]]]]]]]]]]

]]

Figure 7-3Figure 7-3

MC MR

$ 90

$131

80 131

70 131

60 131

80 131

90 131

110 131

130 131

150 131

Should the Should the firm produce firm produce the 1the 1stst unit? unit?

Should the Should the firm produce firm produce the 1the 1stst unit? unit?What about What about the 2the 2ndnd unit? unit?What about What about the 2the 2ndnd unit? unit?

What about What about the 9the 9thth unit? unit?What about What about the 9the 9thth unit? unit?

9 units will maximize profitsthe same profit-maximizing resultas with the TR-TC approach!


Chapter 7.3 13

Marginal Revenue-Marginal Cost Marginal Revenue-Marginal Cost ApproachApproach

Short run profit maximization occurs where MR=MC:

1. Rule applies only if producing is preferable to shutting down

2. Rule is an accurate guide to profit maximization for ALL firms

3. Rule can be restated as P=MC for purely competitive firms, since MR=P


Chapter 7.3 14

Figure 7 - 3

0

40

80

120

160

200

0 2 4 6 8 10

Output

Cos

t & R

even

ue

MCMC

ATCATC

AVCAVC

AFCAFC

9

131131

Find the Find the quantityquantitywhere MR=MCwhere MR=MC

97.7897.78

Find ATCFind ATC

Profit = 9 X (131 - 97.78) = 299


Chapter 7.3 15

Loss-Minimizing CaseLoss-Minimizing Case

• Suppose price falls from $131 to $81…


Chapter 7.3 16

Q TFC TVC TC

0 $100 $ 0 $ 100

1 100 90 190

2 100 170 270

3 100 240 340

4 100 300 400

5 100 370 470

6 100 450 550

7 100 540 640

8 100 650 750

9 100 780 880

10 100 930 1030Figure 7-4Figure 7-4

MC MR

$ 90

$81

80 81

70 81

60 81

80 81

90 81

110 81

130 81

150 81

]]]]]]]]]]]]]]]]

]]

Firm should Firm should produce the produce the first 6 unitsfirst 6 units

Firm should Firm should produce the produce the first 6 unitsfirst 6 units


Chapter 7 17

Figure 7 - 4

0

40

80

120

160

200

0 2 4 6 8 10

Output

Cos

t & R

even

ue

MCMC

ATCATC

AVCAVC

AFCAFC

818191.6791.67

Loss = 6 X (81 - 91.67) = -64.02 < TFC


Chapter 7.3 18

Shutdown CaseShutdown Case

• Suppose the price falls even further, to $71…


Chapter 7.3 19

Figure 7- 5

0

40

80

120

160

200

0 2 4 6 8 10

Output

Cos

t & R

even

ue

MCMC

ATCATC

AVCAVC

AFCAFC

7171

9494Loss = 5 X (71 - 94) = -115>TFC

5When price is belowWhen price is below

minimum AVC, the firm minimum AVC, the firm should shut downshould shut down

When price is belowWhen price is belowminimum AVC, the firm minimum AVC, the firm

should shut downshould shut down


Chapter 7.4 20

PP

QQ

MCMCATCATCC

ost

s an

d r

even

ues

(d

oll

ars)

Co

sts

and

rev

enu

es (

do

llar

s)

At every price, theAt every price, theMR = MC pointMR = MC point

indicates the quantityindicates the quantitybeing produced...being produced...

At every price, theAt every price, theMR = MC pointMR = MC point

indicates the quantityindicates the quantitybeing produced...being produced...

AVCAVC

Figure 7-6 Figure 7-6 Marginal Cost and Short-Run SupplyMarginal Cost and Short-Run Supply


Chapter 7.4 21

PP

QQ

MCMCATCATC

Record theRecord thequantity beingquantity being

supplied forsupplied foreach priceeach price

Co

sts

and

rev

enu

es (

do

llar

s)C

ost

s an

d r

even

ues

(d

oll

ars)

PP33 MRMR33

QQ33

AVCAVC

Marginal Cost and Short-Run Marginal Cost and Short-Run SupplySupply


Chapter 7.4 22

PP

QQ

MCMCATCATC

MRMR22

MRMR33PP22

PP33

QQ22 QQ33

At a lower priceAt a lower pricea lower quantitya lower quantitywill be suppliedwill be supplied

At a lower priceAt a lower pricea lower quantitya lower quantitywill be suppliedwill be supplied

Co

sts

and

rev

enu

es (

do

llar

s)C

ost

s an

d r

even

ues

(d

oll

ars)

AVCAVC



Chapter 7.4 23

PP

QQ

MCMCATCATC

MRMR22

MRMR33

MRMR44

PP22

PP33

PP44

QQ33QQ44

At a higher priceAt a higher pricea higher quantitya higher quantitywill be suppliedwill be supplied

At a higher priceAt a higher pricea higher quantitya higher quantitywill be suppliedwill be supplied

QQ22

Co

sts

and

rev

enu

es (

do

llar

s)C

ost

s an

d r

even

ues

(d

oll

ars)

AVCAVC



Chapter 7.4 24

QQ

PP

PP11

MCMC

MRMR11

AVCAVC

ATCATC

MRMR22

MRMR33

MRMR44

MRMR55

PP22

PP33

PP44

PP55

QQ22 QQ33QQ44 QQ55

Firm should notFirm should notproduce produce below Pbelow P22

Firm should notFirm should notproduce produce below Pbelow P22

Co

sts

and

rev

enu

es (

do

llar

s)C

ost

s an

d r

even

ues

(d

oll

ars)



Chapter 7.4 25

QQ

PP

PP11

MCMC

MRMR11

AVCAVC

ATCATC

MRMR22

MRMR33

MRMR44

MRMR55

PP22

PP33

PP44

PP55

QQ22 QQ33QQ44 QQ55

Co

sts

and

rev

enu

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do

llar

s)C

ost

s an

d r

even

ues

(d

oll

ars)

Short-runShort-runsupply curvesupply curve(Above AVC)(Above AVC)

Short-runShort-runsupply curvesupply curve(Above AVC)(Above AVC)



Chapter 7.4 26

Marginal Cost and Short-run Marginal Cost and Short-run SupplySupply

• Firm’s short-run supply curve is the portion of its MC curve above minimum AVC

• Diminishing Returns, Production Costs, and Product Supply

• Supply curve shifts:– A wage increase shifts the supply curve

upward and to the left (decreasing in supply)– Technological progress would shift the

supply curve downward to the right (increasing in supply)


Chapter 7.4 27

MCMC

AVCAVC

88

DD

80008000

DD

$111$111$111$111

1000 firms1000 firms

IndustryIndustryFirmFirm

(price taker)(price taker)

QQ QQ

PP PPS=S=MCs MCs

Figure 7-7Figure 7-7Competitive Equilibrium for a Firm and Competitive Equilibrium for a Firm and

the Industrythe Industry

ATCATCEconomicEconomic

ProfitProfitEconomicEconomic

ProfitProfit


Chapter 7.4 28

Table 7-4 Output Determination in Table 7-4 Output Determination in Perfect Competition in the Short RunPerfect Competition in the Short Run

Question AnswerShould this firm produce?

Yes, if P ≥ minimum ATC; this means that the firm is profitable or that its losses are less than its fixed cost

What quantity should the firm produce?

Produce where MR (=P) = MC; there, profit is maximized or loss is minimized

Will production result in economic profits?

Yes, if P > ATC (TR > TC)


Chapter 7.5 29

Profit Maximization in the Long Profit Maximization in the Long RunRun

• Assumptions:– Entry and Exit Only– Identical Costs– Constant-Cost Industry


Chapter 7.5 30

The Goal of Our AnalysisThe Goal of Our Analysis

• In the long run, p = minimum ATC

• Because:1. Firms seek profit and avoid losses2. Firms are free to enter and exit

the industry


Chapter 7.5 31

PP

QQ

MCMC PP

QQ

SS11

IndustryIndustry1000 firms1000 firms

FirmFirm(price taker)(price taker)

ATCATC

MRMR$60$60$50 $50 $40$40

100100

$60$60$50 $50 $40$40

100,000100,000

DD11

Figure 7-8 Figure 7-8 Entry Eliminates Economic ProfitsEntry Eliminates Economic Profits

DD22

Economic Profits


Chapter 7.5 32

PP

QQ

MCMCPP

QQ

DD11

SS11

ATCATC

MRMR$60$60$50 $50 $40$40

100100

$60$60$50 $50 $40$40 DD22

100,000100,000

SS22

IndustryIndustry110,000 firms110,000 firms


Entry Eliminates Economic ProfitsEntry Eliminates Economic Profits

110,000110,000

New Equilibrium with more firmsNew Equilibrium with more firms


Chapter 7.5 33

PP

QQ

MCMC PP

QQ

DD11

SS11

ATCATC

MRMR$60$60$50 $50 $40$40

100100

$60$60$50 $50 $40$40

100,000100,000

IndustryIndustry1000 firms1000 firms


Figure 7-9 Exit Eliminates LossesFigure 7-9 Exit Eliminates Losses

DD22

Economic Loss


Chapter 7.5 34

PP

QQ

MCMC PP

QQ

DD11

SS11

ATCATC

MRMR$60$60$50 $50 $40$40

100100 90,00090,000

DD22

SS33

100,000100,000

$60$60$50 $50 $40$40

IndustryIndustry90,000 firms90,000 firms


Exit Eliminates LossesExit Eliminates Losses

New equilibrium with fewer firmsNew equilibrium with fewer firmsNew equilibrium with fewer firmsNew equilibrium with fewer firms


Chapter 7.5 35

Long-Run EquilibriumLong-Run Equilibrium

• If price > min ATC– profits attract new firms– as S increases, price drops to min

ATC

• If price < min ATC– losses cause firms to exit– as S decreases, price rises to min

ATC

• So, in the long run, p = min ATC


Chapter 7.5 36

Long-run SupplyLong-run Supply

• Crucial factor is whether the number of firms in the industry affects the costs of individual firms


Chapter 7.5 37

QQ

P=$50P=$50

DD11

QQ11

SS11

QQ22

PP

Figure 7-10 Long-run Supply for a Figure 7-10 Long-run Supply for a Constant-Cost Industry Is HorizontalConstant-Cost Industry Is Horizontal

DD22

Demand Demand increasesincreasesDemand Demand increasesincreases

P>$50P>$50

DD22

QQ22

Profits Profits attract new attract new

firmsfirms


firmsfirms

Price remains the same in the long runPrice remains the same in the long runPrice remains the same in the long runPrice remains the same in the long run


Chapter 7.5 38

PP

QQ

P=$50P=$50

DD11

QQ11

Figure 7-11 Long-run Supply for an Figure 7-11 Long-run Supply for an Increasing-Cost Industry Is UpslopingIncreasing-Cost Industry Is Upsloping

SS11 Demand Demand increasesincreasesDemand Demand increasesincreases

DD22

P>>$50P>>$50

QQ22


firmsfirms


firmsfirms

In the long run, greater supply is offered at a In the long run, greater supply is offered at a higher pricehigher price

In the long run, greater supply is offered at a In the long run, greater supply is offered at a higher pricehigher price


Chapter 7.5 39

PP

QQ

P=$50P=$50

DD11

QQ11

Long-run Supply for a Decreasing-Long-run Supply for a Decreasing-Cost Industry Is DownslopingCost Industry Is Downsloping

SS11 Demand Demand increasesincreasesDemand Demand increasesincreases

DD22

P>$50P>$50Profits Profits

attract new attract new firmsfirms


firmsfirms

P<$50P<$50

QQ22

long-run Slong-run S

In the long run, greater supply is offered at a In the long run, greater supply is offered at a lower pricelower price

In the long run, greater supply is offered at a In the long run, greater supply is offered at a lower pricelower price


Chapter 7.6 40

Figure 7-12 Figure 7-12 Pure Competition and EfficiencyPure Competition and Efficiency

PP

QQ

PP MRMR

QQ

MCMCATCATC

Price = MC = Minimum ATCPrice = MC = Minimum ATC(normal profit)(normal profit)

Price = MC = Minimum ATCPrice = MC = Minimum ATC(normal profit)(normal profit)


Chapter 7.6 41

• Productive Efficiency– P = Minimum ATC

• Allocative Efficiency– P = MC

Pure Competition and EfficiencyPure Competition and Efficiency


Chapter 7.6 42

Allocative Efficiency andAllocative Efficiency andConsumer and Producer SurplusConsumer and Producer Surplus

• Consumer Surplus is the difference between what the consumer is willing to pay and the market price

• Producer Surplus is the difference between the marginal cost of production and the market price

• At equilibrium, consumer and producer surplus is maximized


Chapter 7.6 43

Figure 7-12 Long-Run Equilibrium:Figure 7-12 Long-Run Equilibrium:A Competitive Firm and MarketA Competitive Firm and Market

PP

QQ

PPee

QQee

Consumer Surplus

Producer Surplus

The sum of consumer and producer surplus is maximized


Chapter 7.6 44

• Productive Efficiency– P = Minimum ATC

• Allocative Efficiency– P = MC

• Dynamic Adjustments– purely competitive markets adjust

to restore efficiency when disrupted by changes in the economy

Pure Competition and EfficiencyPure Competition and Efficiency


Chapter 7.6 45

The “Invisible Hand” RevisitedThe “Invisible Hand” Revisited

• The efficient allocation of resources in perfect competition comes about because businesses and resource suppliers seek to further their self-interest

• Both business profits and consumer satisfaction are maximized


Chapter 7 46

Chapter SummaryChapter Summary

7.1 Four Market Structures 7.2 Characteristics of Pure Competition

and the Firm’s Demand Curve 7.3 Profit Maximization in the Short Run

– MR ( = P) = MC ; TR – TC is the highest 7.4 Marginal Cost and Short-Run Supply

– Firm’s short-run MC that Lies above its AVC 7.5 Profit Maximization in the Long Run 7.6 Pure Competition and Efficiency

– P = ATC = MC

Documents

Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 7 PERFECT COMPETITION Part Two: Microeconomics of Product Markets