© 2006 mcgraw-hill ryerson limited. all rights reserved.1 chapter 10: perfect competition prepared...

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 1

Chapter 10: Perfect Competition

Prepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology


Perfect Competition

The concept of competition is used in two ways in economics.

Competition as a process is a rivalry among firms.

Competition as a market structure.


Competition as a Process

Competition involves one firm trying to take away market share from another firm.

As a process, competition pervades the economy.


Perfectly Competitive Market

A perfectly competitive market is one in which economic forces operate unimpeded.

It has highly restrictive assumptions which provide us with a reference point we can use in comparing different markets.


Perfectly Competitive Market

In a perfectly competitive market:

The number of firms is large. The firms' products are identical. There is free entry and exit, that is, there are no

barriers to entry. There is complete information. Firms are profit maximizers. Both buyers and sellers are price takers.


Necessary Conditions for Perfect Competition Firms' products are identical.

This requirement means that each firm's output is indistinguishable from any other firm’s output.

Firms sell homogeneous product.


Necessary Conditions for Perfect Competition There is free entry and free exit.

Firms are free to enter a market in response to market signals such as price and profit.

Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.


Necessary Conditions for Perfect Competition There are no barriers to entry.

Barriers sometimes take the form of patents granted to produce a certain good.


Necessary Conditions for Perfect Competition There are no barriers to entry.

Technology may prevent some firms from entering the market.

Social forces such as bankers only lending to certain people may create barriers.

There must also be free exit, without incurring a loss.


Necessary Conditions for Perfect Competition There is complete information.

Firms and consumers know all there is to know about the market – prices, products, and available technology.

Any technological breakthrough would be instantly known to all in the market.


Necessary Conditions for Perfect Competition Firms are profit maximizers.

The goal of all firms in a perfectly competitive market is profit and only profit.

The only compensation firm owners receive is profit, not salaries.

There is no non-price competition (based on quality, brand name, or the like).


Necessary Conditions for Perfect Competition Both buyers and sellers are price takers.

A price taker is a firm or individual who takes the market price as given.

Neither supplier nor buyer possesses market power.


Definition of Supply and Perfect Competition If all the necessary conditions for perfect

competition exist, we can talk formally about the supply of a produced good.


Definition of Supply and Perfect Competition Supply is a schedule of quantities of goods

that will be offered to the market at various prices.


Definition of Supply and Perfect Competition When a firm operates in a perfectly

competitive market, its supply curve is that portion of its short-run marginal cost curve above average variable cost.


Definition of Supply and Perfect Competition That the number of suppliers be large means

that they do not have the ability to collude (act together with other firms to control price or market share).


Definition of Supply and Perfect Competition Other conditions make it impossible for any

firm to forget about the hundreds of other firms waiting to replace their supply.

A firm's goal is specified by the condition of profit maximization.


Definition of Supply and Perfect Competition Even if the conditions for a perfectly

competitive market are not met, supply forces are still strong and many of the insights of the competitive model can be applied to firm behaviour in other market structures.


Demand Curves for the Firm and the Industry The demand curve facing the firm is different

from the industry demand curve.

A perfectly competitive firm’s demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.


Demand Curves for the Firm and the Industry Individual firms will increase their output in

response to an increase in demand even though that will cause the price to fall thus making all firms collectively worse off.

Each firm in a competitive industry is so small that it does not need to lower its price in order to sell additional output.


Market supply

Marketdemand

1,000 3,000

Price$10

8

6

4

2

0Quantity

Market Firm

Individual firm demand

Market Demand Curve Versus Individual Firm Demand Curve

10 20 30

Price$10

8

6

4

2

0Quantity

A B C


Profit-Maximizing Level of Output The goal of the firm is to maximize profits.

Profit is the difference between total revenue and total cost.


Profit-Maximizing Level of Output When it decides what quantity to produce it

continually asks how changes in quantity would affect its profit.


Profit-Maximizing Level of Output What happens to profit in response to a

change in output is determined by marginal revenue (MR) and marginal cost (MC).

A firm maximizes profit when MC = MR.


Profit-Maximizing Level of Output Marginal revenue (MR) – the change in total

revenue associated with a one-unit change in quantity.

Marginal cost (MC) – the change in total cost associated with a one-unit change in quantity.


Marginal Revenue

A perfect competitor accepts the market price as given.

As a result, marginal revenue is equal to price (MR = P).


Marginal Cost

Initially, marginal cost falls and then begins to rise.

Marginal concepts are best defined between the numbers.


Profit Maximization: MC = MR To maximize profits, a firm should produce

where marginal cost equals marginal revenue.


How to Maximize Profit

If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.

The supplier will continue to produce more as long as marginal cost is less than marginal revenue.


How to Maximize Profit

The supplier will cut back on production if marginal cost is greater than marginal revenue.

Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.


Price = MR Quantity Total Cost Marginal Cost

35 0 40

28

35 1 68

20

35 2 88

16

35 3 104

14

35 4 118

12

35 5 130

17

35 6 147

22

35 7 169

30

35 8 199

40

35 9 239

54

35 10 293


BC

Area1

P = D = MR

Costs

1 2 3 4 5 6 7 8 9 10 Quantity

60

50

40

30

20

10

0

A

MC

Marginal Cost, Marginal Revenue, and Price

Area 2


C

AP = D = MR

Costs

1 2 3 4 5 6 7 8 9 10 Quantity

60

50

40

30

20

10

0

AB

MC

Marginal Cost, Marginal Revenue, and Price

0123456789

10

$28.0020.0016.0014.0012.0017.0022.0030.0040.0054.0068.00

Price = MR Quantity Produced

Marginal Cost

$35.0035.0035.0035.0035.0035.0035.0035.0035.0035.0035.00


Marginal Cost Curve Is the Firm’s Supply Curve The marginal cost curve, above the point

where price exceeds average variable cost, is the firm's supply curve.


Marginal Cost Curve Is the Firm’s Supply Curve The MC curve tells the competitive firm how

much it should produce at a given price.

The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price.


Marginal Cost Curve Is the Firm’s Supply Curve

A

B

CMarginal cost

Cos

t, P

rice

$70

60

50

40

30

20

10

0 1 Quantity2 3 4 5 6 7 8 9 10


Firms Maximize Total Profit

Firms seek to maximize total profit, not profit per unit.

Firms do not care about profit per unit.

As long as an increase in output yields even a small amount of additional profit, a profit-maximizing firm will increase output.


Profit Maximization Using Total Revenue and Total Cost Profit is maximized where the vertical

distance between total revenue and total cost is greatest.

At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.


TC TR

0

Tot

al c

ost,

rev

enue

$385350315280245210175140105

7035

Quantity1 2 3 4 5 6 7 8 9

Maximum profit =$81

$130

Loss

Loss

Profit

Profit =$45

Profit Maximization Using Total Revenue and Total Cost


Total Profit at the Profit-Maximizing Level of Output The P = MR = MC condition tells us how

much output a competitive firm should produce to maximize profit.

It does not tell us how much profit the firm makes.


Determine Profit and Loss From a Table of Costs Profit can be calculated from a table of costs

and revenues.

Profit is determined by total revenue minus total cost.


Determine Profit and Loss From a Table of Costs The profit-maximizing output choice is not

necessarily a position that minimizes either average variable cost or average total cost.

It is only the choice that maximizes total profit.


Costs Relevant to a Firm


Determine Profit From a Graph Find output where MC = MR.

The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.


Determine Profit From a Graph Find profit per unit where MC = MR.

To determine maximum profit, you must first determine what output the firm will choose to produce.

See where MC equals MR, and then draw a line down to the ATC curve.

This is the profit per unit.


Determine Profit and Loss From a Graph The firm makes a profit when the ATC curve

is below the MR curve.

The firm incurs a loss when the ATC curve is above the MR curve.


Determine Profit and Loss From a Graph Zero economic profit or loss occurs where MC=MR.

Firms can earn zero economic profit or even a loss where MC = MR at the relevant output.

Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs at the relevant output.


(a) Economic Profit (b) Zero economic profit (c) Loss

Determine Profits Graphically

Quantity Quantity Quantity

Price65 60 55 50 45 40 35 30 25 20 15 10

5 0

65 60 55 50 45 40 35 30 25 20 15 10

5 01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12

D

MC

A P = MR

B ATCAVC

E

Profit

C

MC

ATC

AVC

MC

ATC

AVC

Loss

65 60 55 50 45 40 35 30 25 20 15 10

5 0 1 2 3 4 5 6 7 8 910 12

P = MRP = MR

Price Price


Shutdown Point The firm will shut down if it cannot cover its

variable costs.

A firm should continue to produce as long as price is greater than average variable cost.

If price falls below that point it makes sense to shut down temporarily and save the variable costs.

The firm still pays fixed costs.


Shutdown Point

The shutdown point is the point at which the firm will be better off if it shuts down than if it stays in business.


Shutdown Point

If total revenue is more than total variable cost, the firm’s best strategy is to temporarily produce at a loss.

It is taking less of a loss than it would by shutting down.


MC

P = MR

2 4 6 8 Quantity

Price

60

50

40

30

20

10

0

ATC

AVC

Loss

A$17.80

Shutdown Decision


Short-Run Market Supply and Demand While the firm's demand curve is perfectly

elastic, the industry demand is downward sloping.

Industry supply is the sum of all firms’ supply curves.


Short-Run Market Supply and Demand In the short run when the number of firms in

the market is fixed, the market supply curve is just the horizontal sum of all the firms' marginal cost curves.


Short-Run Market Supply and Demand Since all firms have identical marginal cost

curves, a quick way of summing the quantities is to multiply the quantities from the marginal cost curve of a representative firm by the number of firms in the market.


Market Supply In the long run, the number of firms may

change in response to market signals, such as price and profit.

As firms enter the market in response to economic profits being made, the market supply shifts to the right.

As economic losses force some firms to exit, the market supply shifts to the left.


Profits as Signals


Long-Run Competitive Equilibrium Profits and losses are inconsistent with long-

run equilibrium.

Profits create incentives for new firms to enter, output will increase, and the price will fall until economic profits fall to zero.

The existence of losses will cause firms to leave the industry.


Long-Run Competitive Equilibrium Only at zero profit will entry and exit stop.

The zero profit condition defines the long-run equilibrium of a competitive industry.


Long-Run Competitive Equilibrium

MC

P = MR

0

60

50

40

30

20

10

Price

2 4 6 8 Quantity

SRAC LRAC


Long-Run Competitive Equilibrium Zero profit does not mean that the

entrepreneur does not get anything for his efforts.


Long-Run Competitive Equilibrium In order to stay in business the entrepreneur

must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative).


Long-Run Competitive Equilibrium Normal profits are included as a cost.

Economic profits are profits above normal profits.


Long-Run Competitive Equilibrium Firms with super-efficient workers or

machines will find that the price of these specialized inputs will rise.

Rent is the income received by those specialized factors of production.


Long-Run Competitive Equilibrium The zero profit condition is enormously

powerful.

As long as there is free entry and exit, price will be pushed down to the average total cost of production.


Increase in Demand

An increase in demand leads to higher prices and higher profits.

Existing firms increase output.

New firms enter the market, increasing output still more.

Price falls until all profit is competed away.


Increase in Demand

If input prices remain constant, the market is a constant-cost industry, and the new equilibrium will be at the original price but with a higher output.


Increase in Demand

If the the market is a constant-cost industry, the new equilibrium will be at the original price but with a higher market output.

A market is a constant-cost industry if the long-run industry supply curve is perfectly elastic (horizontal).


Increase in Demand

The original firms return to their original output but since there are more firms in the market, the total market output increases.


Increase in Demand

In the short run, the price does more of the adjusting.

In the long run, more of the adjustment is done by quantity.


Profit$9

10120

FirmPrice

Quantity

B

A

Market Response to an Increase in Demand

Market

Quantity

Price

0

B

A

C

MC

AC

SLR

S0SR

D0

7

700

$9

8401,200

D1

S1SR

7


Long-Run Market Supply

In the long run firms earn zero profits.

If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry.


Long-Run Market Supply

Two other possibilities exist:

Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity.

Decreasing-cost industry – factor prices fall as industry output expands.


Increasing-Cost Industry

If inputs are specialized, factor prices are likely to rise in response to the increase in the industry-wide demand for inputs to production increases.


Increasing-Cost Industry

This rise in factor costs would force costs up for each firm in the industry and increases the price at which firms earn zero profit.

Therefore, in increasing-cost industries, the long-run supply curve is upward sloping.


Decreasing-Cost Industry

If input prices decline when industry output expands, individual firms' cost curves shift down.

The price at which firms break even now decreases, and the long-run market supply curve is downward sloping.


Canadian Retail Industry

During the 1990s the Canadian retail industry illustrated how a competitive market adjusts to changing market conditions.


Many retailers were lost or absorbed by competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others.

Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy.



As prices fell, P=MR fell below their ATC.

But since price remained above the AVC, many firms closed their less profitable locations and continued to operate.



When demand did not recover, firms ran out of options.

Many firms realized as they moved into the long run that they have to exit the Canadian retail industry.



Price

Quantity

MC

ATC

AVC

P = MR

Loss

Shutdown Decision


Perfect Competition

End of Chapter 10

© 2006 mcgraw-hill ryerson limited. all rights reserved.1 chapter 10: perfect competition prepared...

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