CH 14: Perfect Competition

Characteristics of Perfect Competition

1. Both buyers and sellers are price takers

• A price taker is a firm (or individual) who takes the price determined by market supply and demand

• If a firm charges above the market price they will not sell any units (will not earn revenue)

Characteristics of Perfect Competition

• 2. There are many firms

• 3. There are NO barriers to entry

• Easy entry and exit of firms

Characteristics of Perfect Competition

• 4. Firms’ products are identical (that means the competitor’s goods are perfect substitutes)

• 5. There is complete information• Consumers know all about the market including prices,

products, and available technology

Characteristics of Perfect Competition

• 6. Firms are profit-maximizing

– P=D=MR=AR (Use “MR. DARP” to remember the labeling)

– The demand curve is perfectly elastic (since the firm is a price taker)

– Price will be determined by market equilibrium

– Marginal revenue (MR) is the same as price

– Average revenue (AR), the revenue generated per unit sold, is the same as MR

Perfect Competition: Demand Curve

• Market graph

• The market demand curve is always downward sloping

• Firm graph

• The demand curve is derived from market equilibrium

• It is always a horizontal line—a perfectly elastic demand curve

–This is because the firm is a price taker

–Therefore, P=MR=D=AR

Perfect Competition: Supply Curve

• Because the marginal cost curve tells how much of a good a firm will supply at a given price, the portion of the marginal cost curve above AVC is the firm’s supply curve

Profit Maximizing Level of Output

• The goal of the firm is to maximize profits

–Profit=TR-TC

•(Total revenue – Total costs)

• For a perfectly competitive firm, profit is (P – ATC)(Q) at the profit-maximizing level of output

Profit Maximizing Level of Output

• The profit-maximizing condition of a perfectly competitive firm is: MC = MR

–Marginal cost (MC) is the change in total cost associated with a change in quantity

–Marginal revenue (MR) is the change in total revenue associated with a change in quantity

•Every time a perfectly competitive firm sells a unit, they earn marginal revenue

•Since they are a price taker, P=MR (which also equals AR)

Profit Maximizing Level of Output

• A firm maximizes total profit, not profit per unit

• If MR > MC, a firm can increase profit by increasing output

• If MR < MC, a firm can increase profit by decreasing output

Graphing Perfect Competition

• There are two graphs:

–One is the market/industry graph

–The other is the firm graph

–They are drawn as side-by-side graphs

Graphing Perfect Competition

• Start with a standard supply and demand graph to represent the market (label this graph market)

–Identify market price and quantity (P1 and Q1)

• Take equilibrium price over to your second graph by drawing a dotted line

Graphing Perfect Competition

• On your second graph, label it firm

• Draw your marginal cost curve

• Draw your ATC (location varies depending on if the firm is making a profit, loss, or zero economic profit)

• Make a “big dot” where MC intersects MR—this is your profit maximizing P and Q

–Take the big dot all the way down to the quantity axis

Drawing the Graph: Perfect CompetitionProfit in the Short Run

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

MC

ATC

Qprofit max

Profit

Market Firm Since P>ATC at the profit maximizing quantity, this firm is earning a profit

Drawing the Graph: Perfect CompetitionLoss in the Short Run

14-15

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

MC ATC

Qprofit max

Loss

Market Firm Since P<ATC at the profit maximizing quantity, this firm is earning a loss

Drawing the Graph: Perfect CompetitionZero Economic Profit (Normal Profit) in the Long Run

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

MC

ATC

Qprofit max

Market Firm Since P=ATC at the profit maximizing quantity, this firm is earning zero economic profit

Perfect Competition in the Long-Run

• In the long run perfect competitors make zero economic profit (normal profit)

• WHY?

•Due to the entry and exit of firms

•If a profit is being made firms will keep entering the market and compete away the profit

Perfect Competition in the Long-Run

• Normal profit is the amount the owners would have received in their next best alternative (breakeven point; where TR=TC)

• Economic profits are profits above normal profits (where TR exceeds TC)

The Shutdown Point for Perfectly Competitive Firms

• In the short run, fixed costs are sunk costs —they must be paid whether or not the firm produces anything

• A firm pays attention to its variable costs when deciding to shutdown

• As long as a firm is covering its variable costs it should continue producing

• When price falls below AVC is when the firm should shutdown

The Shutdown Point for Perfectly Competitive Firms• The shutdown point is the

point below which the firm will be better off if it shuts down rather than if it stays in business

• If P>min of AVC, then the firm will still produce, but earn a loss

• If P<min of AVC, the firm will shut down

• If a firm shuts down, it still has to pay its fixed costs

AVC

MC

Q

P

ATC

Qprofit max

PShutdownP = D = MR = AR

Perfect Competition: PracticeWhat happens to the graphs if market demand increases?

Profit

P

Q

S1

P1

D1

P

Q

P1

MC

ATC

Q1

Market Firm

D2

P2P2

Q2Q1 Q2

D2=P2=MR2=AR2

D1=P1=MR1=AR1

Perfect Competition: Practice

MC

Q

P

ATC

P = D = MR = AR

Qprofit max

P

Is this firm making a profit, loss, or zero economic profit?

Shade the area that represents total costs

Perfect Competition: Practice

Is this firm making a profit, loss, or zero economic profit?Profit

Shade the area that represents total costsGrey box

MC

Q

P

ATC

P = D = MR = AR

Qprofit max

PProfit

Total costs

Perfect Competition: Constant-cost Industry

• In a constant-cost industry, we assume that the entry and exit of firms has no impact on the cost curves of the firms in the market

–MC and ATC will not change

Perfect Competition: Increasing cost Industry

• In an increasing cost industry we assume that the entrance of new firms increases the demand for the factors of production

–This might increase the cost of employing those resources

–When this happens, the cost curves shift upward

Perfect Competition: Increasing cost Industry

• Graphically, what would happen in an increasing cost industry?

–The entrance of new firms would drive down the price of output and increase the cost curves—profit would be eliminated more quickly here than in a constant-cost industry

–The new long run price would be higher than in a constant-cost industry

Perfect Competition: Decreasing cost Industry

• The other option is a decreasing cost industry (yet to see this in the FRQs)

• This is when the entry of new firms decreases the price of key inputs and causes the cost curves to shift downward

• Could be due to economies of scale and lower per unit-costs

Perfect Competition: Decreasing cost Industry

–The entrance of new firms lowers the price of the output and decrease the cost curves

–Takes longer for profit to be eliminated than in the constant-cost industry

–More firms can enter this market and the new long run price would be lower than in a constant cost industry

Chapter Summary • The necessary conditions for perfect competition are:

1. Buyers and sellers are price takers

2. The number of firms is large

3. There are no barriers to entry

4. Firms’ products are identical

5. There is complete information

6. Sellers are profit-maximizing entrepreneurial firms

Chapter Summary • Competitive firms maximize profit where MR = MC

• Profit is (P – ATC)(Q) at the profit-maximizing level of output

• Perfectly competitive firms shut down if P < AVC

• The supply curve of a competitive firm is its MC curve above

minimum AVC

• The short-run market supply curve is the horizontal sum of the MC

curves above AVC for all the firms in the market

Chapter Summary

• In the short run, competitive firms can make a profit or loss. In the long run they make zero profits.

• If there are profits:

• Firms enter the industry

• Supply increases

• Price decreases, eliminating profit

• If there are losses:

• Firms leave the industry

• Supply decreases

• Price increases, eliminating losses

Chapter Summary

• Constant-cost industries have horizontal long-run supply curves

• Increasing cost industries have upward sloping long-run supply curves

• Decreasing cost industries have downward sloping supply curves