ch. 12: perfect competition

Ch. 12: Perfect Competition.

Selection of price and output Shut down decision in short run. Entry and exit behavior. Predicting the effects of a change in demand,

technological advance, or change in cost. Efficiency of perfect competition

Perfect CompetitionPerfect competition is an industry in which:

Many firms sell identical products to many buyers. No barriers to entry. Established firms have no advantages over new ones. Sellers and buyers are well informed about prices.

Perfect competition arises when When firm’s minimum efficient scale is small relative to

market demand Homogeneous products – only price matters to buyers.

Perfect Competition

• In perfect competition, each firm is a price taker. No single firm can influence the price Each firm’s output is a perfect substitute for the

output of the other firms, Demand for each firm’s output is perfectly elastic.

Perfect Competition– Market demand and supply determine the price that the firm must take. – A firm’s marginal revenue is the change in TR resulting from a one-unit

increase in the quantity sold.– In perfect competition, MR=P.

S

D

MR=P

Industry Firm

P

Perfect Competition

• Firms’s goal: maximize economic profit.

= TR – TC

TR=PXQ

TC=opportunity costs of production, including normal profit for the owner.

Profit Max. in Perfect Comp.

A perfectly competitive firm faces two constraints: A market constraint summarized by the market price

and the firm’s revenue curves A technology constraint summarized by firm’s

product curves and cost curves.

Profit Max. in Perfect Comp.

• 2 decisions in the short run: Whether to produce or to shut down. If the decision is to produce, what quantity to produce.

• A firm’s long-run decisions are: Whether to stay in the industry or leave it. Whether to increase or decrease its plant size.

Profit Max. in Perfect Comp.

• At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

• Profits maximized at 9 units of output.

Profit Max. in Perfect Comp.

• Marginal Analysis– Because MR is constant and MC eventually

increases as output increases, profit is maximized by producing the output at which

(P=)MR = MC

Profit Max. in Perfect Comp.

Profit Max. in Perfect Comp.• Profit = (P-ATC)*Q

Profit Max. in Perfect Comp.

• SR decision to shut down.

= (P-ATC)*Q = (P-AVC)*Q –TFC

If P < minimum of AVC, the firm shuts down temporarily and incurs a loss equal to TFC.

If P> minimum of AVC, the firm produces the quantity at which P=MC, even if profits are negative.

Profit Max. in Perfect Comp.

• The Firm’s Short-Run Supply Curve shows how the firm’s profit-maximizing output

varies as the market price varies, other things remaining the same.

MC curve above minimum of AVC

Graphic representation of firm’s profit maximizing output for various prices

Use the diagram below to answer the next 4 questions.

• SR Industry Supply Curve– The quantity supplied by the industry at any

given price is the sum of the quantities supplied by all the firms in the industry at that price.

– Entry of new firms shifts industry supply curve to the right

– Exit of old firms shifts industry supply curve to the left.

LR adjustments

• In SR, economic profits could be positive, negative or zero.

• In the LR, – Firms enter if economic profits are positive– Firms exit if economic profits are negative.– No entry or exit if economic profits are zero.

Changes in Plant Size

– Firms change their plant size whenever doing so is profitable.

– If ATC exceeds the minimum of LRATC, firms change their plant size to lower costs and increase profits.

– Suppose a new technology emerges that reduces LRATC at a higher level than previously.

Changes in Plant Size– Why can’t a firm survive in LR at Q=6? – Why is LR equilibrium at Q where LRATC is minimized?

LR adjustments• Effect of entry/exit on economic profits in LR• At LR equilibrium

P=MC=ATC=0ATC is at a minimum

Industry Typical Firm

LR adjustments• Effect of increase in demand on economic profits in LR• At LR equilibrium

P=MC=ATC=0ATC is at a minimum

Industry Typical Firm

SR vs. LR Adjustments

• Summary of effects of an increase in demand when starting from a LR equilibrium.

SR effect LR effect

Price

Firm output

Industry output

Number of firms

Profits

ATC

LR equilibrium

Long-run equilibrium occurs in a competitive industry when: is zero, so firms have no incentive to enter or exit the

industry. LRATC is at its minimum, so firms can’t reduce costs by

changing plant size.

Use the diagram below to answer the questions that folllow

External Economies and Diseconomies

• Constant cost industry– Industry output has no effect on a given firm’s ATC

• External economies – decreasing cost industry– Firm’s costs fall as industry output rises

• External diseconomies– Increasing cost industry– Firm’s costs rise as industry output rises

External Economics and Diseconomies

• LR supply curve reflects how change in industry output affects ATC.– External economies LR supply upward sloping– External diseconomies LR supply downward sloping– Constant cost industry LR supply horizontal.

LR adjustment to change in demand with Constant cost industry

Industry Typical Firm

LR adjustment to change in demand with decreasing cost industry

Industry Typical Firm

LR adjustment to change in demand with increasing cost industry

Industry Typical Firm

Technological Advances

• New-technology firms enter and old-technology firms either exit or adopt the new technology.

• Optimal sized firm could be either larger or smaller• Industry supply increases and the industry supply

curve shifts rightward.• The price falls and the quantity increases.• Eventually, a new long-run equilibrium emerges in

which all the firms use the new technology the price has fallen to the minimum average total cost, each firm earns normal profit (zero economic profit)

Competition and Efficiency

• Competitive equilibrium is efficient only if there are no external benefits or costs. – Positive externalities.– Negative externalities.

Applications

• Effect of barriers to entry on competitive market

• SR versus LR effect of increase in variable input price

• SR versus LR effect of commodity taxes