Perfect CompetitionJeremy Wong & Cynthia Ji
• A market where no participants are large enough to set the price of a product
• Many conditions exist for a perfectly competitive market
• Therefore there are few if any, truly competitive markets• Mainly used as a benchmark for other market structures
• Let’s take a look at some of the conditions of a perfectly competitive market!
What is Perfect Competition?
Large number of buyers and sellersConditions
Buyers Sellers
Homogenous/identical products (e.g. no brand loyalty)
Conditions
Example: All window cleaning solutions are the sameBrand A = Brand B = Brand C = Brand D
No barriers to entry and exit from marketConditions
A company can easily enter into a market for a product and just as easily leave that market.
No advantages for established firmsConditions
Firm A (left)
Firm B (below)
Although well established, Firm B does not have any advantages over Firm A
No power to set the market priceConditions
No one firm has market power, the ability to influence the price of a product.
Price determined by industry supply and demand
As a result, the industry demand will be downward sloping demand curve but the firm’s demand will be perfectly elastic (horizontal line).
Suppliers only supply a small portion of the total industry output
Conditions
Example: Manufacturers only have a small market share in the Luxury Automotive Industry
Example: Consumers will know all the available prices for a MacBook Pro
Consumers and producers have perfect market knowledge
Conditions
The aim of firms is to maximize profitConditions
Total Revenue (TR) – Amount of money that a firm makes by selling its products (TR=Price x Quantity)Ex: A firm sells 200 apples for $2 each. The total revenue from selling apples would be 200 multiplied by 2 for a TR of $400.
Average Revenue (AR) – How much revenue a firm receives for a typical unit sold (total revenue divided by number of units sold)Ex: A firm makes $400 from selling 100 widgets. Their average revenue would be 400 divided by 100 to give an AR of $4.
Definitions
Average Total Cost (ATC) – Total cost of producing all units divided by the number of units produced. Includes the opportunity cost of producing the good.Ex: It costs $200 to produce 100 gadgets. By dividing 200 by 100, we get an ATC of $2.
Definitions
• Normal Profit – Exists when total revenue is equal to total costs (minimum profit needed to run the business and the long term profit for perfectly competitive markets). Opportunity cost is not considered.
• Economic/Abnormal Profit – When total revenue is greater than total costs, it is the difference between these two values (can only be achieved in the short term in a perfectly competitive market)
Definitions
Marginal Revenue (MR)•The additional revenue generated by increasing product sales by 1 unit•Calculation:__change in total revenue__ change in output quantity•In perfect competition, MR = AR = Price = Demand
Producers can’t set price but can determine how much of a product to produce in order to maximize profit.
Marginal Revenue = Marginal Cost
Maximizing Profit
Marginal Cost (MC)•The change in the total cost that arises when quantity produced changes by 1 unit•Calculation:___change in total cost___change in output quantity
In a perfectly competitive market, marginal revenue is the same as the average revenue per unit:
Marginal Revenue# of Units Total
RevenueMarginal Revenue
1 15 15
2 25 10
3 30 5
# of Units Total Revenue
Marginal Revenue
1 15 15
2 30 15
3 45 15
There can be a positive economic profit which is maximized at the point where MC=MR
Short run profit
Figure 1 Profit Maximization for a Competitive Firm
Copyright © 2004 South-Western
Quantity0
Costsand
Revenue
MC
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
• When MR > MC increase Q• When MR < MC decrease Q• When MR = MC profit maximized
How to calculate profit:Profit=qe(P-ATC)
How to maximize profit:Short run profit
Figure 5 Profit as the Area between Price and Average Total Cost
Copyright © 2004 South-Western
(a) A Firm with Profits
Quantity0
Price
P = AR = MR
ATCMC
P
ATC
Q(profit-maximizing quantity)
Profit
Figure 5 Profit as the Area between Price and Average Total Cost
Copyright © 2004 South-Western
(b) A Firm with Losses
Quantity0
Price
ATCMC
(loss-minimizing quantity)
P = AR = MRP
ATC
Q
Loss
Economic profit = 0Long run profit
• More firms will enter the market• Supply increases, price decreases• Profit decrease and Marginal Revenue decrease• Average Total Cost = Marginal Revenue
If economic profit is less than 0:• Firms will leave the market• Supply decreases, price increases• Profit increase and Marginal Revenue increase• Average Total Cost = Marginal Revenue
Why is economic profit 0?If economic profit is greater than 0:
Long run profit
Why Stay if No Economic Profit is made?• Profit=total revenue – total cost• Total cost include all the opportunity cost of the firm
• The long-run market supply curve is horizontal at this price.
• In a zero-profit equilibrium, the revenue compensates the time and money the owners spent to keep the business going
• Normal profit is still being made
Market Supply with Entry and Exit
Copyright © 2004 South-Western
(a) Firm’s Zero-Profit Condition
Quantity (firm)0
Price
(b) Market Supply
Quantity (market)
Price
0
P = minimumATC
Supply
MC
ATC
Shutdown – A firm’s short run decision to stop production for a period of time due to market conditions.Exit – A firm’s long run decision to leave the market entirely
Variable Costs – Expenses that change depending on the amount of output.Fixed Costs – Stays the same no matter the amount of output.
Shutting Down or Exiting
Decision to Shut Down in the Short Run• A firm shuts down its revenue is less than the variable cost of production.
• Shut down ifTotal Revenue < Total Variable Cost
• Converting this into per unit comparison:• Shut down if
•Price < Average Variable Cost
The Competitive Firm’s Short Run Supply Curve
Copyright © 2004 South-Western
MC
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.
Short run supply curve• The short run supply curve for the firm is the portion of its marginal cost curve that lies above average variable cost since the firm would shutdown once price falls below the average variable cost.
Decision to Exit in the Long Run• The firm exits if the revenue it would get from producing is less than its total cost.
• Exit if Total Revenue < Total Cost
• Converting this into per unit comparison:• Exit if Price < Average Total Cost
Decision to Enter in the Long Run• A firm will enter the industry if such an action would be profitable.
• Enter if TR > TC
• Converting this into per unit comparison:• Enter if P > ATC
Figure 4 The Competitive Firm’s Long-Run Supply Curve
Copyright © 2004 South-Western
MC = long-run S
Firmexits ifP < ATC
Quantity
ATC
0
CostsFirm’s long-runsupply curve
Firmenters ifP > ATC
• The long run supply curve for the firm is the marginal cost curve above the minimum point of its average total cost curve since the firm would exit the market once price falls below average total cost.
Long run supply curve
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.
• In the long run, the increase in supply will push the equilibrium point to the original price with increased quantity.
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
Long-runsupply
P1
1Q
A
MC
An Increase in Demand in the Short Run and Long Run
Copyright © 2004 South-Western
MarketFirm
(b) Short-Run Response
Quantity (firm)0
Price
MC ATCProfit
P1
Quantity (market)
Long-runsupply
Price
0
D1
D2
P1
S1
P2
Q1
A
Q2
P2
B
An Increase in Demand in the Short Run and Long Run
Copyright © 2004 South-Western
P1
Firm
(c) Long-Run Response
Quantity (firm)0
Price
MC ATC
Market
Quantity (market)
Price
0
P1
P2
Q1 Q2
Long-runsupply
B
D1
D2
S1
A
S2
Q3
C
Allocative Efficiency – The firm produces only goods that are most desirable and high in demand (P=MC)
Efficiency
• Productive Efficiency – The firm produces goods at the lowest possible cost which is a point on the Production Possibilities Curve (production at minimum ATC)
Short run Long runEconomic Profit
Yes No
Productively Efficient
No Yes
Allocatively Efficient
Yes Yes
Comparing short run and long run
QUIZ
a) Increasing its outputb) Decreasing its outputc) Increasing its priced) Increasing its resources
Which of the following is not a valid option for a perfectly competitive firm?
Question 1
a) Increasing its outputb) Decreasing its outputc) Increasing its priced) Increasing its resources
Which of the following is not a valid option for a perfectly competitive firm?
Question 1
a) Economic profitb) Allocative efficiencyc) Productive efficiencyd) Normal profit
In the long run, a perfectly competitive firm will achieve all but which of the following?
Question 2
a) Economic profitb) Allocative efficiencyc) Productive efficiencyd) Normal profit
In the long run, a perfectly competitive firm will achieve all but which of the following?
Question 2
a) Always earning an economic profitb) Always productively efficientc) Always allocatively efficientd) Always experiencing an economic loss
If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is:
Question 3
a) Always earning an economic profitb) Always productively efficientc) Always allocatively efficientd) Always experiencing an economic loss
If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is:
Question 3
a) Earning an economic profitb) Productively efficientc) Dominating the other firms in the marketd) Not producing enough output
A firm that is producing at the lowest possible average cost is always:
Question 4
a) Earning an economic profitb) Productively efficientc) Dominating the other firms in the marketd) Not producing enough output
A firm that is producing at the lowest possible average cost is always:
Question 4
a) Earn an economic profitb) Increase its price if it is experiencing an
economic lossc) Produce the quantity where its marginal cost
equals its marginal revenued) Produce at the productively efficient level of
output
A perfectly competitive firm should always:Question 5
a) Earn an economic profitb) Increase its price if it is experiencing an
economic lossc) Produce the quantity where its marginal
cost equals its marginal revenued) Produce at the productively efficient level of
output
A perfectly competitive firm should always:Question 5
a) A total profit of $2b) A total profit of $2000c) A price greater than its marginal costd) An economic loss
If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing:
Question 6
a) A total profit of $2b) A total profit of $2000c) A price greater than its marginal costd) An economic loss
If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing:
Question 6
a) Price will increaseb) Other firms will enter the marketc) Other firms will leave the marketd) Demand will decrease
Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost?
Question 7
a) Price will increaseb) Other firms will enter the marketc) Other firms will leave the marketd) Demand will decrease
Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost?
Question 7
a) Firms will enter the market, price will decreaseb) Firms will enter the market, price will increasec) Firms will exit the market, price will decreased) Firms will exit the market, price will increase
If a perfectly competitive firm is experiencing an economic loss, which of the following will happen?
Question 8
a) Firms will enter the market, price will decreaseb) Firms will enter the market, price will increasec) Firms will exit the market, price will decreased) Firms will exit the market, price will
increase
If a perfectly competitive firm is experiencing an economic loss, which of the following will happen?
Question 8
a) Earn an economic profit, be allocatively efficient, be productively efficient
b) Not earn an economic profit, be allocatively efficient, be productively efficient
c) Not earn an economic profit, not be allocatively efficient, be productively efficient
d) Not earn an economic profit, not be productively efficient, be allocatively efficient
A perfectly competitive firm that is in long run equilibrium will
Question 9
a) Earn an economic profit, be allocatively efficient, be productively efficient
b) Not earn an economic profit, be allocatively efficient, be productively efficient
c) Not earn an economic profit, not be allocatively efficient, be productively efficient
d) Not earn an economic profit, not be productively efficient, be allocatively efficient
A perfectly competitive firm that is in long run equilibrium will
Question 9
a) Experience an economic lossb) Experience an economic profit and produce more
in the short runc) Experience an economic profit and produce less
in the short rund) Experience no economic profit in the short run
A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will
Question 10
a) Experience an economic lossb) Experience an economic profit and produce
more in the short runc) Experience an economic profit and produce less
in the short rund) Experience no economic profit in the short run
A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will
Question 10
a) Rb) Sc) Td) Ue) J
The firm maximizes profit at which output?
Question 11
a) Rb) Sc) Td) Ue) J
The firm maximizes profit at which output?
Question 11
a) Less than $15b) $50c) Above $60d) Between $50
and $60e) $60
The firm’s shutdown price is
Question 12
a) Less than $15b) $50c) Above $60d) Between $50
and $60e) $60
The firm’s short run shutdown price is
Question 12